<bSURVEY - DERIVATIVES: Demand for debt puts swaps at the cutting edge: NEW PRODUCTS by Sarah Laitner: Swaps appear to be the instrument of the future having rapidly become a hedging instrument, a benchmark for interest rates and a credible alternative to bond futures
Financial Times, Sep 25, 2001
By SARAH LAITNER
Swaps market activity has vastly increased in the past few years, and swaps have in many cases ousted government bonds as the reference against which other debt instruments are priced.
Swaps, which were originally used to allow borrowers to exchange the type of debt they could easily raise for the type of debt they really wanted, are now traded by companies and investment banks alike.
"Some time ago swaps were for corporate balance sheet management. Now there is a brave new world and they are the benchmark, a valuation tool and a hedging instrument," says Evan Kalimtgis, head of European credit strategy at Credit Suisse First Boston.
"Swaps are the hedging instrument of choice for investors in the high grade credit market. They are now also a central bank reserve instrument, being employed to manage the maturity of central bank liabilities.
"Additionally, they have become the primary hedging instrument in the US mortgage backed securities market," he adds.
The growth in the swaps market globally has been rapid. At the end of last year, a notional amount of Dollars 48,768bn in interest rate swaps was outstanding, compared with Dollars 36,262bn at the end of 1998, according to data from the Bank for International Settlements.
Interest rate swaps, where borrowers swap funds with fixed interest rates for floating-rate funding, are a big slice of the market, with the parties involved seeking to hedge their interest rate risks.
One of the big attractions of swaps for investors and institutions is that they are very liquid, and available along the whole of the yield curve covering short and long term maturities, whereas diminishing issuance has meant that the supply of government bonds is sometimes not always assured across the yield curve.
The availability of swaps contracts is also attractive to investors who have seen squeezes in bond futures contracts. Recently the lack of supply of German government paper has caused delivery problems for the Bobl contract, the five year German government future.
"Every time there is a liquidity squeeze in the German Bobl future there is an increasing need to find an alternative, which draws people towards swaps," says Andre de Silva, bond strategist at HSBC.
"In spite of the introduction of Eurex (the derivatives market) trading limits, the Bobl future is still prone to squeezes as it is the underlying cash, bond and repo markets that have led to imbalances," he adds.
One of the most fundamental developments in the swaps universe in recent years has been the increasing use of swaps for pricing bonds in the primary market, with investors pricing new bond issues against the swaps curve rather than over the underlying government bonds.
Strategists say this is because the method offers clarity and precision, making it easier to look at the relative value of different credits and different maturities than it is over the underlying government bond curve.
Government bond curves are supposed to be a good predictor of future interest rates. However, government curves can be distorted, meaning that they do not always give a clear indication of interest rates.
"Many people think that the swaps curve is a better predictor of interest rates than government curves, because government curves are sometimes distorted by technical factors," says Gary Jenkins, global head of investment grade credit research at Barclays Capital.
Technical factors have recently distorted the UK government yield curve. Huge demand by pension funds and a lack of supply of government bonds led to prices of long-dated UK gilts rising, inverting the yield curve and not providing a true reflection of interest rate expectations.
The precision and comprehensiveness of the swaps curve makes it attractive to those pricing bonds, according to Mr Jenkins. "The swaps curve does take out distortions in the yield curve and leads to easier analysis across currencies," he says.
However, there are underlying concerns about the risks involved in using them. While many government bonds are seen among investors as being a risk free instrument, "swaps are inherently susceptible to systemic risk, counterparty risk, and shifts in market structure", says Mr Kalimtgis.
Mr de Silva adds: "There are downside risks to swaps. One of these is the volatility of spread movements, which have been seen in extreme cases, such as the crisis in emerging markets in 1998."
The swaps curve in particular is viewed by some as a reflection of banks' credit quality. "But this is not particularly true in the short term" says Mr Jenkins. "Swaps move quickly, and banks credit quality tends to move like an oil tanker - very slowly."
Further derivatives products have been created. In March, the London International Financial Futures Exchange started trading two, five and 10-year futures on swaps - the swapnote contracts - with an average daily trading volume of 25,000.
Copyright: The Financial Times Limited
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