What does the swap spread tell us about the market, and why can it sometimes go negative?

The swap spread is one of the most informative credit market indicators, and understanding negative swap spreads is a Level II favorite.

Definition:

Swap Spread = Fixed rate on interest rate swap - Treasury yield (same maturity)

For example, if the 10-year swap rate is 4.15% and the 10-year Treasury yields 3.90%, the swap spread is 25 bps.

What the Swap Spread Reflects:

The swap rate embeds SOFR/LIBOR-based risk (essentially bank credit risk), while Treasuries reflect sovereign risk. So the swap spread captures:

1. Banking sector credit risk — Higher spread = more concern about bank solvency
2. Liquidity conditions — Tighter liquidity = wider spreads
3. Supply/demand dynamics — Heavy Treasury issuance can push Treasury yields up (narrowing the spread)
4. Counterparty risk — Perceived risk in the swap market

Why Swap Spreads Can Go Negative:

This seems paradoxical — why would the swap rate (which embeds bank credit risk) be below the Treasury yield (supposedly 'risk-free')?

Causes of Negative Swap Spreads:

1. Treasury supply glut — Massive government bond issuance pushes Treasury yields up relative to swap rates. When the US deficit is enormous, the sheer volume of Treasuries depresses their price (raises yield).

1. Regulatory demand for swaps — Post-2008 regulations require banks to use interest rate swaps for hedging, creating strong demand for receiving fixed in swaps (pushing swap rates down).

1. Balance sheet constraints — Holding Treasuries consumes bank balance sheet (leverage ratio rules). Swaps are off-balance-sheet, so banks prefer swaps to Treasuries as hedging instruments.

1. Foreign central bank selling — When foreign holders sell Treasuries (for FX intervention or portfolio rebalancing), Treasury yields rise while swap rates are unaffected.

Historical Context:

30-year swap spreads turned negative in 2008 and have remained persistently negative since ~2015. 10-year spreads went negative during periods of extreme Treasury supply.

Exam Tip: Be prepared to explain both positive and negative swap spreads. A common question presents market conditions (e.g., heavy government issuance, banking stress) and asks you to predict the direction of swap spreads.

Explore fixed income analytics in our CFA Level II course.