Swap Spreads
A swap spread is the gap between the fixed rate on an interest-rate swap and the yield on a Treasury of the same maturity, and its sign and size say a lot about balance-sheet capacity and funding stress, not just interest-rate expectations.
Prerequisites: Interest Rate Swaps, How the Treasury Market Works
A pension fund can get the same fixed-rate exposure two ways: buy a Treasury bond, or enter a swap paying fixed. If both pay a fixed rate for taking similar duration risk, you'd expect the two rates to sit close together. They usually don't, and the gap between them — the swap spread — is one of the most watched relative-value numbers in rates trading.
The swap spread is the swap's fixed rate minus the Treasury yield of the same maturity. A positive spread means the swap rate is higher; that used to be the norm. Since around 2015, long-maturity swap spreads have often gone negative — the swap rate sits below the Treasury yield — because balance-sheet constraints on dealers and heavy Treasury issuance changed who can arbitrage the gap.
Why it isn't zero
Drag the curve's level and slope controls above and picture two curves sitting almost on top of each other — the Treasury curve and the swap curve. Their gap at each maturity is the swap spread. It moves for reasons that have little to do with interest-rate expectations: Treasury supply (more issuance can cheapen Treasuries relative to swaps, widening spreads), the balance-sheet cost banks charge to run swap books (post-crisis capital rules made holding swap exposure more expensive, which can push long-dated swap spreads negative), and demand from pension funds and insurers hedging long liabilities with swaps rather than bonds.
Worked example
The 10-year swap rate is 3.85%. The 10-year Treasury yield is 4.00%. The swap spread is:
A hedge fund believes this spread is too negative and will revert toward zero. It receives fixed on the swap (locking in 3.85%) and simultaneously shorts a 10-year Treasury note, effectively paying the 4.00% yield to finance the short. If the spread narrows to -5bp because Treasury yields fall relative to swap rates, the fund profits from the 10bp of convergence — roughly $10,000 per $1 million of DV01-matched notional per basis point, scaled by however the position was sized.
What this means in practice
Swap-spread trades are a classic relative-value strategy precisely because they isolate the spread — the trader is close to duration-neutral between the swap and Treasury legs, so profit comes from the spread moving, not from the level of rates. But the trade carries real financing risk: it requires repo-financing the short Treasury position, and if that bond goes special, the financing cost can eat the expected profit or force the position to unwind at a loss.
Swap spreads also serve as a broader market gauge beyond any single trade. A widening spread across the curve can signal heavier Treasury issuance relative to demand, while a sharp move toward negative territory on long maturities often reflects dealers pulling back from balance-sheet-intensive positions around quarter-end reporting dates — the same regulatory capital pressures that show up in repo rates around those dates too.
Negative swap spreads on long maturities confuse people who learned the "swap rate is bank credit risk, Treasury is riskless, so swaps should yield more" rule from an earlier era. That relationship flipped once balance-sheet costs, not credit risk, became the dominant driver of the spread.
Practice in interviews
Further reading
- Klingler and Sundaresan, 'An Explanation of Negative Swap Spreads'