Analysis: Swapscreditnov01

Recent market developments may have reduced the prospects for continued credit-swap spread correlation. For example, the possibility of renewed Treasury deficits and sufficient Treasury supply may remove the idiosyncratic risk of Treasuries and again permit effective hedging of spread product with Treasuries.

Recent Market Developments and Shifts in Correlation

Recent events have influenced market dynamics, potentially reducing the prospects for continued credit-swap spread correlation. For instance, the possibility of renewed Treasury deficits and sufficient Treasury supply may remove the idiosyncratic risk of Treasuries and again permit effective hedging of spread product with Treasuries.

Quantitative Portfolio Strategy Analysis

A study has concluded that Treasuries were no longer a perfect proxy for risk-free interest rates, nor a benchmark for fixed-income instruments, especially for long duration ones. Identifying the Benchmark Security in a Multifactor Spread Environment

The Relationship between Swap Spreads and Credit Spreads

The relationship between swap spreads and credit spreads is complex, with correlation increasing as the market becomes more correlated.

Correlation Between Swap Spreads and Credit Spreads

A standard interest rate swap works as follows. Two parties contract to exchange payments based on an agreed notional amount for a period of time, known as the term of the swap. Typically, Party A makes quarterly interest payments on the notional amount, based on the 3-month London Inter Bank Offer Rate (LIBOR) observed at the beginning of each three-month period.

Quantitative Portfolio Strategy Analysis

In turn, Party B makes semiannual interest payments on the same notional amount, but at a fixed coupon rate known as the swap rate. The stream of payments tied to LIBOR is called the floating leg of the swap.

Recent Events and Credit-Swap Spread Correlation

Recent events have reduced the prospects for continued credit-swap spread correlation. For example, the possibility of renewed Treasury deficits and sufficient Treasury supply may remove the idiosyncratic risk of Treasuries and again permit effective hedging of spread product with Treasuries.

A 10-Year Backtest Reveals...

A 10-year backtest reveals that swap spreads have actually become less correlated with credit spreads over time. This increased correlation has a positive feedback effect, leading investors to increase their use of swaps as a hedge for spread product.

What the Data Actually Shows

Treasuries are no longer a reliable benchmark for risk-free interest rates or fixed-income instruments, especially for long duration ones. As a result, Treasuries have lost their value as a hedging instrument in the context of spread products.

Actionable Conclusion Header

The increased correlation between swap spreads and credit spreads has led to a new area of research. The Lehman Brothers Quantitative Portfolio Strategy team has launched total return indices for swaps, which will be described in a separate research paper.