Loosing Ground: U.S. Treasurys

Signaling the difficulties ahead for the U.S. government debt market, another historic moment occurred this week: the 10-year swap rates falling below the 10-year Treasury yield (see the Financial Times report below). Since the swaps market’s inception, this had never happen. Swap rates should be trading above Treasury rates simply because the risk characteristics of the latter are less vis-à-vis the former. Swap rates, in layman terms, provide a reference into what the borrowing costs of a non-government borrower would be. Treasury rates are the anchor known as the “risk-free” rate used in many cash flow discounting scenario analysis. What can be said about such analysis when an alternate, yet imperfect substitute, risk-free interest rate moves higher? The answer: misleading. Fundamentally, this is why capital markets all around are significantly overvalued.

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Flight from Treasuries to swaps increases

By Michael Mackenzie in New York
Published: March 25 2010 (Financial Times)

Tuesday's historic inversion between US swap rates and 10-year Treasury yields intensified yesterday, as traders were forced to cut loss-making positions and investors dumped cash bonds in favour of derivatives ahead of the ending of the first quarter next week.

At the peak of the selling pressure yesterday, swap rates fell nearly 10 basis points below the yield on US Treasuries. On Tuesday, the swap rate closed 2bp below Treasury yields, the first time since swaps emerged in the 1980s that there has been an inversion between triple A rated Treasuries and lower-rated money market rates.

Falling swap rates coincided with the yield on 10-year Treasury notes jumping to 3.85 per cent from 3.70 per cent, as loss-making trades between swaps and government paper were cut by traders. The rate for seven-year swaps also fell below that of seven-year Treasury yields for the first time yesterday.

Swap rates typically trade at a premium to Treasury yields as their funding cost, Libor, is higher than that of "risk free" Treasuries. However, heavy Treasury debt issuance has helped drive the recent inversion. Analysts say that the proximity of quarter-end was another driver of inversion as investors do not want to hold cash bonds on balance sheets and would rather use swaps, which are off-balance instruments.

"This is a combination of corporate issuance and the fact that swaps are less balance-sheet intensive than Treasuries ahead of the quarter-end," said Ales Li, strategist at Credit Suisse.

Swap rates have slowly narrowed against the backdrop of record government debt issuance after trading 60bp above Treasuries in 2008.

Analysts say the inversion may hold for some time as investors stretch for yield beyond Treasuries, as they need to invest this year's strong inflows into bond funds from money market funds.
"The rate is a signal that the market has a huge appetite for alternative spread product to Treasuries," said Brian Yelvington, strategist at Knight Libertas Research.