Fear and Loathing in Interest-Rate Swaps

The world's supposedly safe but credit spreads keep widening.
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Swap meet? I almost went to one once, but the vision of a tie-dyed fiftysomething trying to convince me that his Popsicle-stick scale model of Jerry Garcia's Haight Ashbury flat was worth at least two of my vintage Honus Wagner baseball cards dissuaded me.

Swap spreads? I hadn't heard of them until I made a questionable vocational choice and opted for fixed income over dentistry. Swaps sound like a Wall Street creation designed to amaze and confuse, which indeed they do. But the interest-rate swap market is currently the technical driving force that determines how much corporations pay to borrow, what you must pay for a mortgage and how I spend my nondental professional life. What is most topical is that the current state of the swap market seems to represent a disconnect with reality, or more accurately, with investment reality.

The swaps idea started innocently enough, back in the late 1970s, when gaps in the U.S. capital markets presented a gaping opportunity to bankers to make a buck. In those bygone days, corporations needing money had two options: the bank or the public debt market. There were two options for paying interest: fixed-rate or floating. Since all corporations aren't created equal, the rates they had to pay reflected two basic variables: the chance that they would repay at all (credit rating) and how long they wanted the money.

On the Street, those variables determine the "vig," but in a suit and tie it's called the "credit premium" or "spread." If a U.S. steel company wanted to fund a new smelter, no one wanted to provide the money, and whoever did wanted it back in a week. If you were, say,

Coca-Cola

(KO) - Get Report

, bankers got in line to give you 30-year money you didn't even need, just to tell their friends.

Into this breach stepped the U.S. capital markets to make both sorts of parties happy -- for the appropriate fee.

Let's say that in those days the

Treasury

could borrow for 90 days at 8% and for 30 years at 10%. Our poor steel maker would be offered 90 days at 10%, but 30-year money would demand an extortionate 18%, while happy Coke would be close to the Treasury curve at 9% short and 12% long. You see the profit opportunity? Our beleaguered steel company needs the money for 30 years, since smelters aren't investments that pay off quickly. Coke, on the other hand, may from time to time need short-term loans to pay for sugar until it sells a case of soda.

Helpful Bankers: Always in the Middle

See it now? A bank or other intermediary persuades the steel company to issue short-term paper at 10% and gets Coke to issue 30-year debt at 12%. The bank, as intermediary, then arranges for the parties to "swap" their interest payments in the following manner: The bank pays Coke the 12% it owes and asks Coke to pay it 8%. Coke thereby swaps its fixed-rate payment into a floating-rate below where it could borrow in the public market. Our steel company agrees to pay the bank a fixed rate of 15% for 30 years in return for receiving a floating rate at 8%. Steel is therefore in the hole for 2 points against the 10% short-term market rate it could get, but it saves 3 points for 30 years against what the market would charge. Both parties end up saving money -- net, of course, of the bank's fees.

As will happen with any profitable undertaking, the swap market has exploded both in size and in complexity. You name it, someone is willing to swap it. Currencies? No problem. Libor vs. fed funds? In my sleep. The classic fixed- vs. floating-rate swap market has matured into one of the world's deepest markets and now represents a new alternative for that classic corporate financing problem: hedging. Which brings us to our current tale.

End of the World, Part Two?

Everybody on the planet is issuing debt. Corporate bond issuance in the past three months has exceeded $300 billion, with more in the pipeline. Why the rush? The

Fed

hasn't helped. Grumblings about rate increases have scared issuers into thinking rates are headed higher. Y2K hasn't convinced issuers that rates are going higher, but it has served to rush issuance to avoid the uncertainty of year-end.

Herein lies the problem, or opportunity, depending on your market outlook. The spread over Treasuries that companies pay to enter into a swap is a function of two variables. First, since you're entering into a contract with a financial institution, you are wise to consider whether or not that entity will be around to meet its obligation. That's the credit spread. Last fall, when Russia was defaulting, the president was on the ropes and

Seinfeld

was going off the air, the spreads that companies were demanding vs. Treasuries doubled from about 50 basis points to almost 100. When the Fed breathed life into stock-market bulls with three quick rate reductions, the gloom lifted, credit risk subsided and interest-rate swap spreads fell back into the mid-60-basis-point range.

Disaster was averted. We welcomed back the "new paradigm," stock prices raced ahead and all was right with the world. Except in the world of swaps. Over the past several weeks, the spread over Treasuries on swaps has widened to 110 basis points, or worse than last fall. Huh? Things sure feel a lot better than they did back then, so what's the deal?

Here comes the payoff from my years of economic training: supply and demand. Remember that everybody in the world is issuing debt, and they're doing it as quickly as they can. If you're concerned that rates are going up, and you want to lock in your cost of borrowing until your bonds are actually issued (it takes time for the Wall Street road show to come to town, stuff you with day-old chicken and convince you to buy a company's bonds), you can pay a fixed rate of interest on an interest-rate swap and sleep better.

If you enter into a swap to pay 7% fixed for 10 years, and rates rise to 8% by the time you issue, you have made a profit on your swap that offsets the higher rate you pay on your debt. Since everyone is 100% convinced that rates are going up, and they're all trying to fit through the issuance door prior to year-end, everybody wants to enter into a swap to pay a fixed rate of interest. If everybody wants to pay a fixed rate of interest right now, then you're gonna have to make it worth my while. You want to pay me 7%? You, in the back of the room, you want to pay me 7.1%?

And so it goes. As eager issuers, trying to hedge their exposure to prospective changes in market rates, boost the rates they are willing to pay, the spread vs. Treasuries goes up, and we get to our current disconnect.

If the world is indeed a safer place than it was last fall, yet interest-rate swap spreads are wider, something has to give. Either the world isn't so safe and these spreads represent an increased credit risk, or the technical supply/demand imbalance will abate and swap spreads will narrow. Though you can never be sure how these things will play out, you can take some comfort in the fact that if everybody is on the same side of a trade, it may be time to go the other way.

Jim Sweeney is the head of fixed income investments at Aeltus Investment Management in Hartford, Conn. His commentary on the financial markets is based upon information thought to be reliable and is not meant as investment advice. Aeltus manages institutional investment accounts and acts as adviser to the Aetna Mutual Funds. While Sweeney cannot provide investment advice or recommendations, he invites you to comment on his column by writing his colleague Jim Griffin at

GriffinJ@aeltus.com.