can someone plz explain this: Since the credit crisis, credit spreads have been increasing. So, swap rates have been decreasing but the bank’s cost of fund rates have been increasing a lot. I understand why the bank’s cost of funds will increase, but how come the swap rates are decreasing, shouldn’t they be increasing too with the crisis?
swap rates have come down as libor has sort of followed the feds easing. swap spreads have widened significantly however as the “funding” risk premium or whatever you want to call it has increased.
Swap rates consist of the base rate with the swap spread on top of it. The two components respond to different economic drivers and pretty much have life of their own. The base rate (which would be the government rate) is controlled by the central bank in the short end and by long-term inflation expectations the long end. The swap spread responds to liquidity concerns and credit fears. Which is why the recent easings by the Feb have brought down the base rate (more so in the short end and that’s why we have seen significant yield curve steepening as well) but overall the swap rates remain high as the swap spreads have blown out due to liquidity and credit concerns.
thx guys. but i still dont totally understand. ok so i understand that the swap rate is the govt rate + swap spread and the cost of funds rate is the govt rate + cost of funds spread now you say the swap spread responds to liquidity concerns and credit fears. arent these two variables also factors in the cost of funds spread. so i dont understand what the difference is between the swap spread and the cof spread that has been causing one to go up and the other to go down. if the fed has reduced interest rates, then i understand that the short term govt rates will decrease, but the govt rates are the same in both equations so this still couldn’t cause one to increase and the other to decrease?
Whya do you think COF has been rising? I think it has fallen a percent or so this year. So I guess I don’t undertsand the question.
Swap spread and COF spread do respond to the same drivers (credit/liquidity) but in different ways. Swap curve is constructed out of ED futures and swap rates and is market observable and common to all market participants. Whereas swap spread did blow out, ED futures are very liquid and settled daily (minimal credit concerns). COF curve is, on the other hand, institution specific and will be constructed out of the debt you issue to fund yourself. In today’s environment, it is painfully difficult to issue, say, 5yr debt or any other kind of term debt, just because market participants sit on their liquidity and are not willing to do business. So I guess while both curves essentially respond to the same risk factors, they do so in different ways.
What are you all looking at that says COF has risen? Do you mean risen since 2003 or something? Didin’t COFI fall like 50 bp last month? Edit: And I think swap rates and cof are wildly different animals. One is an explicit interest rate that is tradable and trillions of dollars are directly impacted by it. The COF is some bank reported number that could be influenced by giving away toasters and is not directly tradable.
Indeed, COF is indeed institution-specific and typically, it will be composed of rates at which you can issue , say, BAs or CP in the short end and bonds or other longer term debt in the long end. COF is usually used internally for determining profitability and for transfer pricing. I can’t think of a place where COF curves would be publicly posted. COF over the last month would really be down, I guess early March was the Armageddon moment with BSC going under and now people thinking the worst may be over. Relative to last August, COF would be dramatically up. Still, the real issue is, can you really raise funds at your COF yields, and how much? Liquidity is still terrible.
I don’t think I know what COF is, I just assumed jimjohn was taking about cost of funds for companies, or more specifically credit spreads. While we’ve had a nice little rally in credit over the past couple weeks, mainly in the derivatives indices, it’s still fair to say credit spreads have widened meaningfully in the past several months. I’ll give you a real simple way to think about it which I think you will find helpful. Let’s think of investing in a 5 yr corporate bond. By lending funds to an issuer you receive a yield-to-maturity. First let’s split the YTM into two pieces, the risk free-rate and the credit spread. The risk free rate is the 5yr on-the-run treasury yield, and the credit spread in this context is known as the treasury spread. That’s YTM on the bond minus the risk free rate. Now, we can further break that treasury spread down into too pieces, what we’ll call the funding spread and the “pure” credit spread. The funding spread is the swap spread, and it represents the general level of funding risk in the market, or the credit risk inherent in LIBOR, which is pretty low as it is a group of 12 or so AA rated banks. The credit spread is the spread compensating you for the idiosyncratic credit risk of the issuer. In the market this spread is often called the z-spread, the LIBOR spread, or the asset swap spread (ASW). Technically the ASW is slightly difference as it adjusts for the fact that the bond might be trading away from par, but it’s pretty close to the z-spread for investment grade bonds in normal markets so I wouldn’t worry about that too much, the concept is the same. So in your question you’ve hit on a pretty interest occurrence over the past few weeks. Conditions have tightened in the short-term funding markets as LIBOR has set higher and overnight markets have become a little more skittish. A lot of people say this was related to quarter-end window dressing at European banks and similar balance sheet management for the fiscal year-end at Asia. At the same time, credit was screaming tighter driven in large part by short-covering as the ramifications of aggressive Fed intervention set in. Swap spreads generally follow LIBOR but are also driven by other technical factors with fancy names like “convexity hedging”, “repo specialness”, and “fixed rate receiving by corporate issuers”. Basically, I would think of swaps as moving with systemic risk in the short-term interbank funding markets, while credit spreads capture the credit risk of all corporate issuers. Hope this is somewhat helpful, ended up being a bit long-winded.
COF has been decreasing because the Fed has been cutting interest rates AND introducing various liquidity facilities like the TAF, TSLF etc. to bring down funding costs. Swap rates have been decreasing because the “govt rate” component of the swap rate has been decreasing, BUT the swap spread component has been INCREASING. Why? Because swap spreads are a measure of counterparty risk, and given the turmoil in the current market place, where we have investment banks continuously writing down assets, counterparty risk is rising.
was going to reply to thread…but ^ said it perfectly, COF & swap rates decreasing, swap spreads increasing for the aforementioned reasons
thanks guys it makes more sense now. i guess when i said cof rates have been increasing and swap rates have been decreasing, i just meant in general since mid 2007. i havent been talking about whats been going on in the last month or so.