Interest rate swaps are an integral part of the fixed income market. These derivative contracts, which typically exchange – or swap – fixed-rate interest payments for floating-rate interest payments, are an essential tool for investors who use them in an effort to hedge, speculate, and manage risk.
An interest rate swap is an agreement between two parties to exchange one stream of interest payments for another, over a set period of time. Swaps are derivative contracts and trade over-the-counter. The most commonly traded and most liquid interest rate swaps are known as “plain vanilla” swaps, which exchange fixed-rate payments for floating-rate payments based on SOFR (Secured Overnight Financing Rate), which is a broad measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities. Although there are other types of interest rate swaps, such as those that trade one floating rate for another, plain vanilla swaps comprise the vast majority of the market. Investment and commercial banks with strong credit ratings are swap market makers, offering both fixed and floating-rate cash flows to their clients. The counterparties in a typical swap transaction are a corporation, a bank or an investor on one side (the bank client) and an investment or commercial bank on the other side. After a bank executes a swap, it usually offsets the swap through an inter-dealer broker and retains a fee for setting up the original swap. If a swap transaction is large, the inter-dealer broker may arrange to sell it to a number of counterparties, and the risk of the swap becomes more widely dispersed. This is how banks that provide swaps routinely shed the risk, or interest rate exposure, associated with them. Initially, interest rate swaps helped corporations manage their floating-rate debt liabilities by allowing them to pay fixed rates, and receive floating-rate payments. In this way, corporations could lock into paying the prevailing fixed rate and receive payments that matched their floating-rate debt. (Some corporations did the opposite – paid floating and received fixed – to match their assets or liabilities.) However, because swaps reflect the market’s expectations for interest rates in the future, swaps also became an attractive tool for other fixed income market participants, including speculators, investors and banks.
The “swap rate” is the fixed interest rate that the receiver demands in exchange for the uncertainty of having to pay the short-term SOFR (floating) rate over time. At any given time, the market’s forecast of what SOFR will be in the future is reflected in the forward SOFR curve.
For illustrative purposes only.At the time of the swap agreement, the total value of the swap’s fixed rate flows will be equal to the value of expected floating rate payments implied by the forward SOFR curve. As forward expectations for SOFR change, so will the fixed rate that investors demand to enter into new swaps. Swaps are typically quoted in this fixed rate, or alternatively in the “swap spread,” which is the difference between the swap rate and the equivalent local government bond yield for the same maturity. A similar principle applies when looking at money itself and considering interest as the price for money. If the real return (adjusted for inflation) on a financial asset differs between two countries, investors will flock to the country with the higher returns. Interest rates have to change to stop this movement. The theory behind this relationship is called the interest rate parity theory. (When looking at interest rates, it is important to distinguish between real rates and nominal rates, with the difference reflecting the rate of inflation. The higher the expected inflation in a country, the more compensation investors will demand when investing in a particular currency.)
The plot of swap rates across all available maturities is known as the swap curve, as shown in the chart below. Because swap rates incorporate a snapshot of the forward expectations for SOFR, as well as the market’s perception of other factors such as liquidity, supply and demand dynamics, and the credit quality of the banks, the swap curve is an extremely important interest rate benchmark.
Source: Bloomberg as of 29 February 2024. For illustrative purposes only. Not indicative of the past or future performance of any PIMCO product.
Although the swap curve is typically similar in shape to the equivalent sovereign yield curve, swaps can trade higher or lower than sovereign yields with corresponding maturities. The difference between the two is the “swap spread”, which is shown in the chart below. Historically the spread tended to be positive across maturities, reflecting the higher credit risk of banks versus sovereigns. However, other factors, including liquidity, and supply and demand dynamics, mean that in the U.S. today the swap spread is negative at longer maturities.
Source: Bloomberg as of 29 February 2024. For illustrative purposes only. Not indicative of the past or future performance of any PIMCO product.
Because the swap curve reflects both SOFR expectations and bank credit, it is a powerful indicator of conditions in the fixed income markets. In certain cases, the swap curve has supplanted the Treasury curve as the primary benchmark for pricing and trading corporate bonds, loans and mortgages.
At the time a swap contract is put into place, it is typically considered “at the money,” meaning that the total value of fixed interest rate cash flows over the life of the swap is exactly equal to the expected value of floating interest rate cash flows. In the example below, an investor has elected to receive fixed in a swap contract. If the forward SOFR curve, or floating-rate curve, is correct, the 2.5% he receives will initially be better than the current floating 1% SOFR rate, but after some time, his fixed 2.5% will be lower than the floating rate. At the inception of the swap, the “net present value,” or sum of expected profits and losses, should add up to zero.
However, the forward SOFR curve changes constantly. Over time, as interest rates implied by the curve change and as credit spreads fluctuate, the balance between the green zone and the blue zone will shift. If interest rates fall or stay lower than expected, the “receiver” of fixed will profit (green area will expand relative to blue). If rates rise and hold higher than expected, the “receiver” will lose (blue expands relative to green). If a swap becomes unprofitable or if a counterparty wishes to shed the interest rate risk of the swap that counterparty can set up a countervailing swap – essentially a mirror image of the original swap – with a different counterparty to “cancel out” the impact of the original swap.
Like most non-government fixed income investments, interest-rate swaps involve two primary risks: interest rate risk and credit risk, which is known in the swaps market as counterparty risk.
Because actual interest rate movements do not always match expectations, swaps entail interest-rate risk. Put simply, a receiver (the counterparty receiving a fixed-rate payment stream) profits if interest rates fall and loses if interest rates rise. Conversely, the payer (the counterparty paying fixed) profits if rates rise and loses if rates fall.
Swaps are also subject to the counterparty’s credit risk: the chance that the other party in the contract will default on its responsibility. This risk has been partially mitigated since the financial crisis, with a large portion of swap contacts now clearing through central counterparties (CCPs). However, the risk is still higher than that of investing in a “risk-free” U.S. Treasury bond.