Swap spreads on the move


Swap spreads on the move

Swap spreads, the difference between the yield on daily collateralized swaps and benchmark sovereign debt, are observed for many reasons: amongst others as an economic risk indicator; a measure of investor preferences over time; and an important consideration in setting Liability Driven Investment (LDI) strategies.


This article summarises swap spread developments and considers the implications for pension funds and their interest rate hedging strategies. We examine what pension funds can do to their interest rate hedge to take advantage of this market development.

 

Executive Summary

Swap spread is at historical peak

Since the start of the year the spread between the 10-year euro swap and 10-year German government bond has widened from around 40 bps to around 80 bps. It peaked at 86 bps in 2008. The current widening of the swap spread can be explained by the risk-off mode in financial markets amid concerns about geopolitical stability.

Expected swap spread narrowing

If and as these fears diminish over time, we would also expect the swap spread to narrow. In addition, supply and demand may impact the swap spread in the near term as the ECB’s Pandemic Emergency Purchase Programme (PEPP) will be discontinued by the end of March.

Investors with interest rate sensitive liabilities can profit

For investors currently holding large allocations of highly rated euro government debt with the primary purpose to hedge interest rate risk, highly elevated swap spreads will give pause for thought, particularly in this long-running low yield environment. Current swap spreads (as of March 11, 2022) are offering German government bond investors the potential for additional return over the yield they are expecting from their bonds. In addition, investors who trade their exposure to these bonds for interest rate swaps can benefit significantly if and as swap spreads return to their historical average.

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More about the authors

Peter Spijkman Senior Investment Strategist

Peter Spijkman joined Aegon Asset Management in 2012. He is a senior Investment Strategist in the Fiduciary Services and Investment Solutions team.


Oliver Warren Senior Investment Solutions Consultant


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