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Implications of Divergence between Gilt and Swap Curves
21-23 JUNE 2009
THE GRAND, BRIGHTON
James Walton
Patrick Rowland
Overview
Introduction
Drivers of the swap spread
Recent market conditions
VaR analysis
Implications of current conditions
Introduction What is the risk free rate?
Gilts v swaps
Swap spread
What drives the swap spread?
How can the spread be understood?
Gilt yield
Swap rate
Swap spread
Drivers of the swap spread
Significant research in to the swap spread over past 20 years
Key drivers for the swap spread:
Default risk Liquidity Supply and demand
Challenge is distinguishing between factors
Decomposing the swap spread• Regression of historic data• Results depend on period used and
method.
Factors Impact on gilt yield
Impact on swap rate
Default risk
Liquidity (convenience yield)
Supply and demand
LIBOR-spread
Slope of yield curve
Volatility of interest rates
Term to maturity Spread widens
Drivers of the swap spread
Example output:
Variously conclude that most of the spread is due to liquidity or credit No reliable way of decomposing spread using prices of instruments
Source: Liu, Longstaff & Mandell Source: Feldhutter & Lando
Recent Market Conditions
Source: Bloomberg, as at 16 June 2009
Recent Market Conditions UK Nominal Swap Spreads
Le
hm
an
Co
llap
se
Ce
ntr
al B
an
k a
ctio
n
Qu
an
tita
tive
Ea
sin
g
Incr
ea
se to
QE
Bu
dg
et 2
00
9
-100
-50
0
50
100
Jul-0
7
Aug-0
7
Sep-0
7
Oct-07
Nov-07
Dec-07
Jan-
08
Feb-0
8
Mar
-08
Apr-0
8
May
-08
Jun-
08
Jul-0
8
Aug-0
8
Sep-0
8
Oct-08
Nov-08
Dec-08
Jan-
09
Feb-0
9
Mar
-09
Apr-0
9
May
-09
Jun-
09
No
min
al S
wa
p S
pre
ad
(b
ps
)
10Y Spread
20Y Spread
30Y Spread
LabelsSource: Bloomberg
Recent Market Conditions
UK Inflation Swap Rate
Lehm
an C
olla
pse
Ce
ntr
al B
an
k a
ctio
n
Incr
ea
se to
QE
Bu
dg
et 2
00
9
Qu
an
tita
tive
Ea
sin
g
1.5
2
2.5
3
3.5
4
4.5
5
Jul-0
7
Aug-0
7
Sep-0
7
Oct-07
Nov-07
Dec-07
Jan-
08
Feb-0
8
Mar
-08
Apr-0
8
May
-08
Jun-
08
Jul-0
8
Aug-0
8
Sep-0
8
Oct-08
Nov-08
Dec-08
Jan-
09
Feb-0
9
Mar
-09
Apr-0
9
May
-09
Jun-
09
Infl
ati
on
Sw
ap
Ra
te (
%)
10Y Inflation
20Y Inflation
30Y Inflation
LabelsSource: Bloomberg
Recent Market Conditions
Falling spreads since October 2008. Long term spreads have been negative since.
Quantitative easing in March 2009 decreased gilt yields. Index linked gilts not included in QE program so implied inflation squeezed down
Budget announcement re £220 bn of new gilt supply in 2009/10 led to sharp fall in spreads (ie more negative at long durations)
Recent Market Conditions - LIBOR/SONIA
Source: Bloomberg, 16 June 2009
LIBOR 6 month
LIBOR 3 month
SONIA
Recent Market Conditions - Reasons
Demand – why invest in swaps?
Hedging asset for institutions
Swaps can provide leverage, and thus a greater level of hedge than gilts. Capital may be freed up for growth assets.
Swaps provide a more tailored hedge
Solvency II swaps based discount rate
Recent Market Conditions - Reasons
Supply – why not borrow at swap rates to buy gilts?
Arbitrageurs not functioning, higher internal funding costs, many hedge funds closed. Banks unwilling to expand balance sheet
Transaction costs of arbitrage are high
Institutions relatively slow or unwilling to act on arbitrage opportunities due to advantages of swaps
Subject to calls for cash
Default risk of government (5 year CDS was 160bps in Feb, now 90bps) or payment failure without technical default
VaR Analysis
Fixed Income Yields 2005 - 2009
2%
3%
4%
5%
6%
7%
8%
9%
10%
Jan-
05
Apr-0
5
Jul-0
5
Oct-05
Jan-
06
Apr-0
6
Jul-0
6
Oct-06
Jan-
07
Apr-0
7
Jul-0
7
Oct-07
Jan-
08
Apr-0
8
Jul-0
8
Oct-08
Jan-
09
Apr-0
9
AA Corp AA less CDS
LIBOR Swaps Sonia Swaps
Gilts
VaR Analysis
Use yields to calculate daily returns on 10 year maturity bond for Gilt, Corp AA, Corp AA – CDS* and Swaps
*Sterling CDS estimated using Euro CDS, assuming sterling CDS explain the same proportion of AA-Gov spread as Euro CDS’s do
Upside/Downside VaR Gilt AA AA-CDS Swap
99% 1.12% 1.21% 1.57% 0.96%95% 0.62% 0.59% 0.94% 0.54%5% -0.65% -0.63% -0.89% -0.53%1% -1.11% -1.26% -1.86% -0.86%
VaR Analysis
Bonds valued on a AA or AA-CDS basis have been most volatile
Removing CDS rates from AA yields increases correlation with Gilts
10 year swap rates less volatile than Gilts
Mean, Volatility and Correlations on 4 bases:Gilt AA AA-CDS Swap
Mean 0.01% -0.01% -0.01% 0.01%Volatility 0.40% 0.50% 0.60% 0.35%Gilt 1.00 0.63 0.76 0.84AA 1.00 0.81 0.57AA-CDS 1.00 0.65Swap 1.00
Implications of Current Conditions - PensionsLiabilities
Limited use of direct swaps curve valuations
Assets
Switch cash backed swaps to Gilts/Corporates.
Hedging solutions mix gilts, credit, swaps where most attractive or forced to do so along curve.
Asset swaps (swap Gilt for a LIBOR plus return). Could support interest rate swaps or TRS
Repos (unfunded exposure to ILG or Gilts at preferable rates to swaps)
Implications of Current Conditions - Pensions
Issues to consider:
Level of leverage required
Degree of cashflow matching required
Transaction costs and liquidity
View of future swap spread movements
Implications of Current Conditions - Life
Rebalancing of swap and swaption portfolios Life companies have been more active in hedging using swaps. Given the
spread is this still appropriate? Switching to gilts may not be attractive if need to unwind when position is
reversed
Layering of swaps to lock in spread
Uncertainty over reference rates Current focus is on swaps
Summary
Difficult to analytically decompose swap spread in to components
Long term swap spreads are negative. Some drivers for this are arguably short term (ie liquidity and high cost of capital)… but others will remain (demand for swap hedging over gilts)
Recent conditions give rise to additional issues when valuing liabilities and setting investment strategy
Yield curves working party
Thanks to all the members of the yield curve working party for their contributions:
Joseph Collins – Lucida Con Keating – Brighton Rock Adrian Lawrence – BGI Patrick Rowland – KPMG Shalin Shah – Royal London Andrew Smith – Deloitte James Walton – Aon