Credit spreads widen as investors prefer swaps over Treasuries
The gap between US government bonds and interest rate swaps has widened, creating a pricing anomaly in the credit market. Investors buying bonds from companies like Alphabet pay a premium over Treasuries that is significantly higher than the premium paid over swaps. This difference, known as the credit spread, currently offers a larger reward when measured against swaps than against Treasuries, a fact that has changed how some managers hedge their exposure to interest rate risk.
Why the spread is wide
The US Treasury market faces pressure from government budget deficits and a high volume of issuance. These factors push Treasury yields higher, which makes credit spreads look tighter when measured against those yields. In contrast, the interest rate swap curve, which represents bank-based funding rates, has traded well below government bonds of the same maturity. This results in a negative swap spread, a situation where the swap rate is lower than the risk-free rate.
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Market participants view the swap curve as a better approximation of the true risk-free rate in the current environment. A negative swap spread means that a company’s credit risk is effectively cheaper when priced against swaps than against Treasuries. The resulting difference can be substantial; one analyst noted that a bond from a company like Alphabet might trade at 150 basis points over swaps but only 90 basis points over Treasuries. On the surface, the dollar bond appears expensive, but after hedging back with swaps, it offers a spread closer to 170 basis points.
Shifting exposure
Funds that aim to isolate credit risk are adjusting their hedging strategies to capture this value. By replacing some Treasury futures with interest rate swaps, managers can retain the spread over swaps rather than the spread over Treasuries. This allows investors to buy the same credit risk at a lower effective cost. The shift involves selling bonds in markets where the dislocation between bonds and swaps is smaller and buying bonds in the US dollar market, where the gap is most pronounced.
Portfolio managers have applied this logic to specific holdings. In August, one fund sold euro-denominated bonds and purchased dollar-denominated bonds. The euro market did not show the same dislocation, so the strategy worked to improve the overall yield of the portfolio. Similar trades were executed with other names, including Aegon and Rothesay, which were sold in favor of Allianz and Munich Re. These adjustments improved portfolio quality without significantly sacrificing income.
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Investing in this way means accepting the risk of the swap spread itself. If US Treasuries sell off, the price of the bonds generally falls, but the value of the swap hedge might not keep pace. This could leave the portfolio with a mark-to-market loss if swap rates do not move in tandem with Treasury prices. The swap spread would widen, eroding the benefit of the initial trade.
Historical perspective
Managers believe this risk is manageable. Swap spreads in the US are currently unusually negative by historical standards. Before the financial crisis, 10-year swap spreads were positive, hovering around 60 basis points. Today, the 10-year spread is around -40 basis points, and the 30-year spread is at -70 basis points. These levels are at the wide end of the range observed since 2008, even after accounting for the transition from LIBOR to SOFR.
