Record negative spreads roil U.S. swaps market

By Richard Leong

NEW YORK (Reuters) - A dip in U.S. interest rate swaps that led to negative spreads in recent weeks has raised concerns that other parts of the bond market could be disrupted and raise borrowing costs for the U.S. government.

The decline in swap rates, to below comparable U.S. Treasury yields, was so acute on Thursday that some analysts called it a "flash" event, recalling the U.S. stock market's "flash crash" in May 2010 when the Dow Jones industrial average plunged and rebounded in just 36 minutes.

"It resembled a mini-flash crash, the sort of thing that bristles the hairs upon policy-makers' necks," said David Keeble, head of U.S. rates strategies at Credit Agricole Corporate and Investment Bank in New York.

The market for dollar-based interest rate swaps is huge, at an estimated $107 trillion in notional value, according to the Bank of International Settlements. Swaps are used by mortgage lenders and real estate investment trusts guard against rate changes and by hedge funds and speculators to bet on rates.

Swaps allow the exchange of fixed-rate and floating-rate cash flows for investors and traders to tailor their interest rate exposure.

Nearly all swap spreads for five years and beyond ended on Friday in negative territory.

Analysts have blamed negative spreads on tougher capital rules for Wall Street firms, record corporate bond supply, structural market changes, expectations of a U.S. rate increase and a spike in Treasury bill supply. These factors have caused dealers to cut their swap exposure, which they normally do near the end of the year.

It is unclear whether swap spreads would remain negative even if corporate bond supply slows ahead of the U.S. Federal Reserve's next policy meeting in mid-December.

LOSSES REPORTED

Ellington Residential Mortgage REIT (NYSE: EARN) said on Tuesday it had unrealized losses of $18.7 million, or $2.04 a share, on its interest rate hedging portfolio in the third quarter. Its net loss was $4.8 million, or 53 cents a share.

More funds including REITs (real estate investment trusts) and hedge funds with bad swap positions may be forced to liquidate them by year-end, causing possible ripples in other parts of the bond market, analysts said.

"We believe moves in spreads should be viewed as symptomatic of deeper problems in the Treasury market," J.P. Morgan Securities strategist wrote in a research note on Friday.

Swap rates tend to run higher than U.S. Treasury yields, but in September 10-year swap rates fell below benchmark 10-year Treasuries yields for the first time in five years, according to Tradeweb.

If swap spreads stay negative, Uncle Sam could end up paying $260 billion more in interest in the next 10 years, based on a projected increase in U.S. borrowings to $21 trillion from $13 trillion, J.P. Morgan strategists said.

HEAVY CORPORATE BOND SUPPLY

One of the main factors for record negative swap spreads is the recent flood of debt supply from companies seeking to lock in low rates before the Fed ends its near zero rate policy and to finance acquisitions and dividends.

Demand for swaps has grown as players seek fixed-rate cash flows to hedge the corporate bonds they have issued or purchased, pushing swap rates below Treasuries yields.

On Friday, the 10-year swap spread ended at -10.25 basis points after hitting a record -17.75 basis points on Thursday, while the five-year spread was -5.25 basis points, versus a record -10.75 basis points set a day before, Tradeweb data showed. Two months ago, five-year and 10-year swap spreads were about 5 basis points.

This week, companies raised $32.2 billion in the investment-grade credit market, bringing their year-to-date issuance to $1.145 trillion, according to IFR, a unit of Thomson Reuters.

With a possible Fed rate hike next month in the wake of Friday's robust October jobs report, companies may scramble to sell more bonds in the next five weeks, analysts said.

Also, the U.S. Treasury is expected to ramp up sales of bills in the coming weeks to replenish its coffer.

The Treasury's cash holding was sinking below its minimum $150 billion target as it anticipated exhausting its borrowing capacity earlier this week. The debt ceiling was raised after the White House and leading Republicans reached a deal that became law on Monday.

Dealers will likely require more short-term wholesale funding in the repurchase agreements market to help them hold more Treasury bills. However, banks at this time prefer to either maintain or shrink their balance sheets, instead of making more loans in the repo market.

"Bills compete with government repo and so repo rates are rising in reaction to this issuance onslaught," Keeble said.

(Reporting by Richard Leong; Editing by Richard Chang)

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