The ware housing activity is normally hedged in the U.S. Treasury of financial futures market, leaving the warehouse manager with a spread risk, or the difference between the spread at which he booked the swap with the issuer and where he manages to find a matched counter-party. The relative stability of spreads and a positively sloped yield curve have allowed the market to function reasonably well on this basis with only occasional periods of severe oversupply in any particular maturity. The major houses tend to spread their inventory across the yield curve to reduce risk and to ensure ready availability of a given maturity for particular clients’ requirements.
Bids for bond-related swaps tend to differ between the major houses by only a few basis points: the swap market is quite efficient in price given the few houses who deal in bond market size and maturities. Hence, a premium is placed on creating bond structures which offer the fixed-rate issuer a lower cost and therefore, a better spread LIBOR. Apart from creative bond/ swap structures, the key to successfully operating in this segment of the market for the bond/ swap arranger has been the development of a highly refined sense of timing for the underlying issue. While finding a window in the Eurodollar bond market has always been the sine qua non for a successful lead manager, with the advent and development of the swap market, the focus of the potential lead manager has shifted from an investor window to a spread window. Given that the long term swap market operates on a relatively stable spread level versus US Treasuries and the Eurodollar bond market is notoriously volatile versus Treasuries for different types of issuers, a similar premium to that of creativity applies to the lead manager who can locate a spread window for a particular type of issuer. This creativity and search for a spread window has sometimes led to mis-priced and/ or virtually incomprehensible bond structures but more often than not, bond/ swap structures so created have provided value to both the Eurobond investor and issuer.
However, it is clear that LIBOR spreads available to issuers have declined as the market has become more efficient in pricing the relative value of a given swap: at the outset of the market, a “AAA” issuer could reasonably expect to achieve 75-100 basis points below LIBOR on a bond/ swap; under current market conditions. This same issuer might expect only 25-30 basis points below on a “plain vanilla” bond/ swap. Indeed many issuers, particularly commercial banks, now find it more cost-effective to approach the floating rate note market than the bond/ swap market. The lower spreads available have gone almost entirely to the benefit of the fixed-rate payer; intermediaries have seen their profit margins reduced to a very substantial degree in the primary market. This reduced profitability and lower spreads available has led, in turn, for most bond /swap arrangers to attempt to put potential counter-parties in direct contact with each other and eliminate the intermediation of a commercial bank. This is most often a very difficult process due to timing and credit considerations but there is a strong incentive now among all parties concerned to see whether a direct write is possible on a new issue.
The long term secondary market for interest rate swaps is a highly opportunistic segment of the market. As interest rate fluctuates, a fixed rate provider or taker may find that a substantial profit can be realized by reversing the original swap or canceling the original swap in return for an up-front cash payment. Several reasons can be cited for the slower rate of growth of the interest swap market. The few of them are explained below.
- Banks executing fixed rate bond issues have represented a large portion of the provider side of the swap market. Most of the banks executed a bond/swap to gain long term floating rate funding for their long term floating rate funding for their long term floating rate loans and therefore, have no reason to reverse.
- The odd dates thrown off by swap reversals are often difficult to close in the market and thus what appears to be an interesting price on a spot basis may become substantially less interesting when the odd dates are taken into account.
- Many swap intermediaries do not make markets to their clients with whom the original swaps were written. In this case, now, the only option available is to execute a mirror swap for which up-fronts cash will be difficult to obtain and entails a doubling of credit risks for the reverser.
The market risk may be associated with the fixed flows, there is also risk associated with the LIBOR side. An additional potential risk can be assumed depending on the structure of the swap. When counter-party receives fixed payments semi-annually and pays LIBOR semi-annually, potential risk is minimized.
Despite the problems explained above, the long term secondary market has shown good growth and several houses have sponsored the growth of this segment through commitment of capital, personnel and systems capabilities to market to making in long term swaps.
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