Implications of Divergence between
Gilt and Swap Curves
21-23 JUNE 2009
THE GRAND, BRIGHTON
James Walton
Patrick Rowland
Overview
 Introduction
 Drivers of the swap spread
 Recent market conditions
 VaR analysis
 Implications of current conditions
Introduction

What is the risk free rate?

Gilts v swaps
Swap spread

Swap spread
What drives the swap
spread?
Gilt yield

How can the spread be
understood?
Swap rate
Drivers of the swap spread

Significant research in to the swap
spread over past 20 years

Key drivers for the swap spread:
 Default risk
 Liquidity
 Supply and demand
Factors
Impact on
gilt yield
Impact on
swap rate
Default risk
Liquidity
(convenience yield)
Supply and demand
LIBOR-spread


Challenge is distinguishing between
factors
Slope of yield curve
Decomposing the swap spread
Volatility of interest rates
•
•
Regression of historic data
Results depend on period used and
method.
Term to maturity
Spread widens
Drivers of the swap spread

Example output:
Source: Liu, Longstaff & Mandell


Source: Feldhutter & Lando
Variously conclude that most of the spread is due to liquidity or credit
No reliable way of decomposing spread using prices of instruments
Recent Market Conditions
Source: Bloomberg, as at 16 June 2009
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7
Au
g07
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No
v07
De
c07
Ja
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Ap
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100
-50
-100
10Y Spread
20Y Spread
30Y Spread
Source:
Bloomberg
Labels
Increase to QE
Budget 2009
Quantitative Easing
50
Central Bank action
Lehman Collapse
Nominal Swap Spread (bps)
Recent Market Conditions
UK Nominal Swap Spreads
0
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c08
Ja
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b0
M 9
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5
4.5
2.5
2
UK Inflation Swap Rate
4
Increase to QE
Budget 2009
Quantitative Easing
Central Bank action
Lehman Collapse
Inflation Swap Rate (%)
Recent Market Conditions
3.5
3
10Y Inflation
20Y Inflation
30Y Inflation
Source: Bloomberg
Labels
1.5
Recent Market Conditions

Falling spreads since October 2008. Long term spreads have been
negative since.

Quantitative easing in March 2009 decreased gilt yields. Index linked
gilts not included in QE program so implied inflation squeezed down

Budget announcement re £220 bn of new gilt supply in 2009/10 led to
sharp fall in spreads (ie more negative at long durations)
Recent Market Conditions - LIBOR/SONIA
LIBOR 6 month
LIBOR 3 month
SONIA
Source: Bloomberg, 16 June 2009
Recent Market Conditions - Reasons
Demand – why invest in swaps?

Hedging asset for institutions

Swaps can provide leverage, and thus a greater level of hedge than gilts.
Capital may be freed up for growth assets.

Swaps provide a more tailored hedge

Solvency II swaps based discount rate
Recent Market Conditions - Reasons
Supply – why not borrow at swap rates to buy gilts?

Arbitrageurs not functioning, higher internal funding costs, many hedge
funds closed. Banks unwilling to expand balance sheet

Transaction costs of arbitrage are high

Institutions relatively slow or unwilling to act on arbitrage opportunities due
to advantages of swaps

Subject to calls for cash

Default risk of government (5 year CDS was 160bps in Feb, now 90bps) or
payment failure without technical default
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VaR Analysis
10%
9%
8%
Fixed Income Yields 2005 - 2009
AA Corp
AA less CDS
LIBOR Swaps
Sonia Swaps
Gilts
7%
6%
5%
4%
3%
2%
VaR Analysis

Use yields to calculate daily returns on 10 year maturity bond for Gilt, Corp
AA, Corp AA – CDS* and Swaps
Upside/Downside
VaR
99%
95%
5%
1%
Gilt
1.12%
0.62%
-0.65%
-1.11%
AA
1.21%
0.59%
-0.63%
-1.26%
AA-CDS
1.57%
0.94%
-0.89%
-1.86%
Swap
0.96%
0.54%
-0.53%
-0.86%
*Sterling CDS estimated using Euro CDS, assuming sterling CDS explain the same proportion of AA-Gov spread as
Euro CDS’s do
VaR Analysis
Mean, Volatility and Correlations on 4 bases:
Gilt
AA AA-CDS Swap
Mean
Volatility
Gilt
AA
AA-CDS
Swap
0.01%
0.40%
1.00
-0.01% -0.01%
0.50% 0.60%
0.63
0.76
1.00
0.81
1.00
0.01%
0.35%
0.84
0.57
0.65
1.00

Bonds valued on a AA or AA-CDS basis have been most volatile

Removing CDS rates from AA yields increases correlation with Gilts

10 year swap rates less volatile than Gilts
Implications of Current Conditions - Pensions
Liabilities

Limited use of direct swaps curve valuations
Assets

Switch cash backed swaps to Gilts/Corporates.

Hedging solutions mix gilts, credit, swaps where most attractive or forced
to do so along curve.

Asset swaps (swap Gilt for a LIBOR plus return). Could support interest
rate swaps or TRS

Repos (unfunded exposure to ILG or Gilts at preferable rates to swaps)
Implications of Current Conditions - Pensions
Issues to consider:

Level of leverage required

Degree of cashflow matching required

Transaction costs and liquidity

View of future swap spread movements
Implications of Current Conditions - Life

Rebalancing of swap and swaption portfolios
 Life companies have been more active in hedging using swaps. Given the
spread is this still appropriate?
 Switching to gilts may not be attractive if need to unwind when position is
reversed

Layering of swaps to lock in spread

Uncertainty over reference rates
 Current focus is on swaps
Summary

Difficult to analytically decompose swap spread in to components

Long term swap spreads are negative. Some drivers for this are arguably
short term (ie liquidity and high cost of capital)… but others will remain
(demand for swap hedging over gilts)

Recent conditions give rise to additional issues when valuing liabilities and
setting investment strategy
Yield curves working party

Thanks to all the members of the yield curve working party for their
contributions:







Joseph Collins – Lucida
Con Keating – Brighton Rock
Adrian Lawrence – BGI
Patrick Rowland – KPMG
Shalin Shah – Royal London
Andrew Smith – Deloitte
James Walton – Aon