KfW $4 billion issue underscores new normal of negative swap spreads

by Louise Bowman and Tessa Wilkie

On Wednesday, February 17, KfW priced a $4 billion five-year dollar benchmark at 44 basis points over mid-swaps and 36.1bp over treasuries, the widest spread over swaps for the issuer at this maturity in seven years. 

The deal, which was lead managed by Goldman Sachs, JPMorgan and TD Securities, is a stark demonstration of the impact that the unprecedented inversion of dollar swap spreads – which are now negative all the way along the curve from four years – is having on issuers. 

“We looked at the pricing levels with ambiguity: on one hand we needed to overcome issuing at historically wide spreads; on the other hand it gave us confidence that the deal would work in an overall still challenging market,” said Petra Wehlert, head of capital markets at KfW, when the deal priced.

The challenge that issuers face is that although those pricing levels may be historically wide, they are probably here to stay. That is because of the negative dollar swap spread. 

Subadra Rajappa, Société Générale

“Swap spreads are not going to revert back to normal; they are going to remain negative,” says Subadra Rajappa, head of US rates strategy at Société Générale. “When swap spreads turned negative in 2010 that was due to one large hedge fund flow and things quickly reverted. People thought it would be the same this time, but it will not.”

While the 30-year swap spread has been negative for over a year, 10-year swaps turned negative last summer and the three-year briefly turned negative in January this year. The five-year dollar swap spread was minus 7bp on February 16, having been 2.5bp last October, 13.5bp in August 2015 and 20.25bp in October 2014. 10 years swap spreads are minus 13bp and 30 year are minus 49bp.

“We’ve issued a five-year dollar global every year since 2013. Each year we have priced it at mid-swaps plus 1bp and the spread over US treasuries was somewhere between 13bp and 17 bp,” Laura Fan, head of funding, treasury division at the IADB tells Euromoney. 

“This year we printed a five-year in January and paid mid-swaps plus 29bp and a spread to treasuries of 26bp. That was the clearing level for a $3 billion transaction.”

The swap-spread inversion has been attributed to many causes: reserve selling by several central banks (most notably China); high levels of corporate debt issuance driving demand for hedging and the use of swaps to access rates exposure. But there is little doubt about the impact of regulation – primarily the leverage ratio and supplementary leverage ratio – on bank balance-sheet capacity and market liquidity.

“Second-order effects such as central bank reserve selling are having an impact but this would not explain the levels where forwards are trading,” says Francis Yared, head of European rate strategy at Deutsche Bank. “We have modelled it and the best we can get to is swap spreads at close to zero. But they are at minus 11.”

The reason is the cost to banks under Basel III of providing the repo that underpins the treasuries market. Treasuries used to trade more expensively than swaps because swaps were seen as an interbank market and a measure of bank solvency. That has now changed because bonds are a funded instrument (you have to have the cash or repo to buy them) whereas swaps are unfunded so they have become a lot more popular. In addition, as swaps are cleared, they are no longer a measure of the interbank market but a measure of clearing houses’ credit quality.

The leverage ratio has made the provision of the repo needed to buy treasuries prohibitively expensive for banks. 

“The leverage ratio is the killer for repo as a traded product,” says Andy Hill, senior director, market practice and regulatory policy, at ICMA. “If you start pricing in the hurdle rate to take repo on balance sheet without the ability to net, it quickly becomes untradeable. It varies from bank to bank, but we’ve heard break-even hurdle rates cited as much as 80bp and higher.”

Yared at Deutsche Bank calculates that if the leverage ratio is the binding constraint without any other factors to reduce its impact, then a simple back-of-the-envelope calculation would indicate that the cost of balance sheet would be about 60bp (6% leverage ratio and 10% return on equity). 

“This is a very rough high-level illustration of the impact of regulation on swap spreads,” he explains. “Treasuries should trade cheap to OIS by 60bp.” However, speaking to Euromoney in early February he observes “Two-year two-year forwards are trading at 40bp and three-year three-years at 50bp. Regulation has generated a regime change in where the swap spread is going to be,” he adds.

That new regime will be very close to zero for some time to come. “Swap spreads have been close to 0 since 2010, and the fact that they pushed through 0 doesn’t change that six-year trend,” says Ralph Axel, rates strategist at BAML. “It’s likely that they’ll be close to either side of 0 until something major changes with treasury supply (deficits) or demand for treasuries (central banks resume buying and/or credit portfolios flow into treasuries),” he predicts.

So issuers will have to get used to it. “KfW has to have access to a broad array of markets so there are other markets we can use to compensate,” KfW’s Wehlert tells Euromoney. "We can obviously do a lot of funding in euros and other currencies but we have €70 billion to raise this year and we consider the US dollar market as a strategic market.