Bond Investment Strategies
Interest Rate Swaps
Interest rate swaps have become more important to the bond markets; most investors will encounter this term and require an understanding of what an interest rate swap is and how it is used. An interest rate swap is an agreement by two entities to exchange or swap floating rate interest payments for fixed rate interest payments - and vice versa. It is important for an individual investor to understand that swaps are between institutions and not between individual investors; however, the result of these swaps may affect his/her portfolio or the price he/she may pay for a particular bond.
The most common type of swap is a “vanilla” swap in which fixed rate interest payments are exchanged for floating rate interest payments based on LIBOR, the London Interbank Offered Rate. LIBOR is the interest rate that banks with high credit ratings from ratings agencies (rating of AA- or above) charge each other for short term financing. LIBOR is set daily and is considered the benchmark for floating short term interest rates. One entity in the swap will get a fixed rate loan rate and the other will get a floating rate loan rate.
The two organisations that participate in the swap are known as “counterparties.” The “payer” in a vanilla swap is the entity that agrees to receive a floating interest rate in exchange for a fixed interest rate. The “receiver” is the entity that agrees to receive a fixed rate in exchange for a floating rate. Commercial and investment banks with high credit ratings are usually the entities that offer both fixed and floating rate swaps.
Swaps are actively traded across many bond issues, with different quality ratings, and are measured on the basis of yield. Swap yield rates plotted on a graph across the various available bond maturities together create a swap curve. The swap curve covers many swap trades and it is reflective of expectations about floating LIBOR interest rates and fixed rate bank credit. The market considers it a good benchmark indicator of yield and therefore of pricing.
Why do I care?
- Corporations may use swaps to exchange loans with floating rates for loans with fixed rates and vice versa to more closely match their needs for financing.
- Some types of bonds have prices that are set in reference to the swap curve, especially if those bonds are less liquid, i.e. after issuance, the bonds don’t trade much.
- The swap rate curve is an important interest-rate benchmark for the bond markets and is commonly used in Europe as the pricing reference for all European Government Bonds.
- Portfolio managers also use swaps to manage interest rate risk and sometimes to lock in interest rates.
Interest- rate swaps have two major risks: interest rate risk and credit risk (also known as counterparty risk).
Swaps have interest rate risks because sometimes interest rates don’t move the way the parties expect them to and instead of the swap exchange sum of expected profits and losses adding up to zero, it doesn’t, in which case a counterparty may set up another swap to cancel out the impact of the first one.
The second type of risk is credit risk, which is that one of the counterparties will default. Since as we noted the banks involved have high credit ratings of AA and above, this is unlikely, but it isn’t risk-free.