By Michael Mackenzie
November 29 2006
SourceSomething highly unusual is afoot in the US interest-rate swap market - and threatens the bottom line for investors holding a particular type of structured note.
For only the second time in recent history, the rate available on longer-dated10-year interest rate swaps has fallen below that on two-year swaps - meaning the yield curve for swaps has followed that for US Treasuries in becoming inverted.
This unexpected situation has put the spotlight on a structured product that allows investors to bet the swaps curve will retain its normal positive slope where longer-dated rates are higher than shorter-dated rates.
Dealers say investors in Asia and other high net worth private banking clients have been buying up these so-called non-inversion notes in the hunt for higher yields than are available on other fixed income investments.
"These notes are popular with retail investors seeking a high quality return that is better than owning standard [Treasury or corporate] bonds," says Steve Rodosky, portfolio manager at Pimco. "The investor sees a nice coupon and is aware of the historical tendency for the swaps curve to not invert."
For every day the curve is not inverted, these notes paid investors a fixed premium of anywhere from1 per cent to 2 per cent more than the three-month London Interbank Offered Rate, the swap market's benchmark floating interest rate. While the curve is inverted, investors get nothing.
The swaps allow investors to bet on changes in interest rates, mainly either to hedge their exposure to rate rises or to gain from falls.
The swap curve has not been inverted since a brief period of five days in February and that was the first time 10-year rates had fallen below two-year rates since the market became fully liquid across all maturities in the early 1990s.
Non-inversion notes have been popular due to the swaps curve's historical resistance to inversion. That is because these derivatives do not represent a risk-free benchmark like US government bonds. Investors in swaps are exposed not only to interest rate changes, but also to the risk that counterparties could fail to pay up; a kind of credit risk.
With the extra amount investors expect to be paid for corporate credit over and above US Treasuries at historically tight levels, credit risk is perceived as low and swaps are not reacting in their usual fashion.
Much as in other derivatives markets, swaps are becoming preferred among many investors as a means of increasing exposure to interest rate moves rather than direct investment in cash Treasuries, which is narrowing the differences between the behaviour of both markets.
When the US Treasuries yield curve inverted during 2000, swap spreads, a measure of the difference between the rate available from the swap market and the Treasury yield, widened, led by longer-dated maturities.
The wider spread pushed swap rates higher and prevented the swap curve from inverting.
In recent weeks, swap spreads have actually been falling while the Treasury curve has become increasingly inverted, with the discount of 10-year yields to two-year yields jumping to 19 basis points from 8bp.
In the swaps market the inversion is more modest, with 10-year swaps at 4.97 per cent, 2bp below the two-year rate, and this inversion has held for much of the past nine trading days.
Investors are wondering whether this is only a reprise of February or something that might intensify.
For several months since early June, the swap curve traded generally in a narrow but positive band, with the 10-year swap between 5bp and 13bp above the two-year rate, even as the government curve became modestly inverted.
That performance was so steady it helped to increase the demand for non-inversion notes, say dealers.
A concern now, particularly for holders of these notes, is the spectre of dealers having to unwind trades that insured against risk of a steeper positive curve.
The trades they would need to get out of these positions could well intensify the current inversion of the swap curve. That would intensify the famine in returns for holders of the non-inversion notes. "We are right on the cusp of hedging flows competing with each other," said Fidelio Tata, derivatives strategist at RBS Greenwich Capital. As holders of non-inversion notes continue to miss out on a return, at some point their patience may snap.
Mr Rodosky says: "There is the prospect investors are not taking in enough premium in the form of the coupon to offset the risk of the curve inverting."
The shape of the curve matters for dealers, as middlemen between issuers and investors. A distinct change in relationship between short and long-term swap rates requires a rebalancing of their positions.
The longer the swap curve is inverted, the greater the pressure for dealers to put on so-called flattener trades, where they sell two-year swaps while buying 10-year swaps.
Many hold the opposite "steepener" trades as insurance against a normal curve. Should 10-year swap rates stay above two-year rates for a long time, such insurance can be cut. That view could gain momentum as other investors sense a trading opportunity and exacerbate the current inversion.
"Now the curve has inverted, the hedging flow may instead reinforce the inversion," says Ciaran O'Hagan, head of fixed income strategy at Société Générale. "So flatteners look more attractive in swaps than in Treasuries, at least out to 10 years."
"Hedging of non-inversion notes [by issuers and dealers acting on their behalf] has accelerated flattening of the swap curve since the curve inverted," said Mr Tata.
Despite prospects of pain for investors and rapid hedging, demand among dealers and buyers of such notes is unlikely to cease.
If the curve were to invert further, Mr Rodosky expects dealers and issuers to structure the notes with a boundary at about minus 25bp instead of zero. Rather than betting the swaps curve would never invert, traders would instead be able to bet it does not invert by as much as 25bp.
Copyright The Financial Times Limited 2006