Mind on Money readers are hereby invited to enter our first-ever year-end contest.
The point of the contest is to come up with a reason for a market anomaly to exist when it shouldn’t. This is the kind of situation that costs people like me lots of money when trading. It’s a prime example the old saw that the market can stay irrational longer than you can stay solvent.
I’m talking about the 30-year swap rate.
For the past year, 30-year swaps have been trading at a lower yield than 30-year Treasuries. When I was new to the bond business and reading the bond market primer “Inside the Yield Book,” it was a given that higher yield is associated with higher risk. Risk takes many forms, but the truth of this assumption about yield spreads was never questioned.
So what, pray tell, is the risk of 30-year Treasury Bonds the market believes is higher than the risk of 30-year interest rate swaps?
It can’t be currency risk, because both are quoted in US Dollars for all payments, both principal and interest. One thing I’m sure the Treasury will always have is access to Dollars to pay its debts. I’m not saying anything about what those Dollars will be worth when you get them, but I’m comfortable assuming the Treasury will definitely pay me $1 million US Dollars for my million-dollar Treasury Bond when it comes due.
It can’t be option risk, because neither one is callable or extendable. Is the market saying the Treasury will decide to force investors to take a ten-year extension when the Long Bond comes due? Is it saying that the Treasury will force borrowers to take their principal early? Is the market simultaneously saying that private market counterparties like banks wouldn’t do the same if some strange circumstances brought about these actions?
It can’t be credit risk, at least the way I look at it. If Treasury Bonds were denominated in Yen or Euros, I might be able to swallow the idea that some bank counterparty could more easily pay the interest and principal than the Treasury. But these aren’t in another currency. The Treasury has the printing press, so Dollar debt simply can’t be safer from a credit perspective when it’s issued by some bank or brokerage firm.
That leaves me with only liquidity risk among the Big Four risks in bond world.
Perhaps the market is remembering the October Surprise of 2001, when the Treasury announced they would stop issuing the 30-year maturity. Of course that announcement came when there was a budget surplus, and the operating cash for the Federal budget did not include as much as $400 billion a year “borrowed off budget,” a fact I suggested at the time meant that Enron was controlling both our energy policy and our Treasury policy.
Still, the staggering size of the swap market for interest rate derivatives gives some credence to this theory. Put simply, the Treasury doesn’t borrow enough to satisfy the demand for non-callable long term investments, so the swap market has to step in. The fact of lower rates on swaps says that even that market can’t satisfy the demand.
While not a more liquid market on a daily basis (though nobody knows for sure), we can say that there are far more 30-year swaps than there are 30-year Treasury Bonds. The liquidity risk idea gets a resounding “maybe.”
Still, if a company or a strong bank or insurance company can get 30-year funding cheaper than the US Government, why aren’t they doing it? Seems like they’d do it until the yields went up (at least until they couldn’t turn around and buy Treasuries to lock in a 30-year profit).
What about the credit issue? Given the fact that nobody is willing to take a counterparty risk for 30 years these days in the private market, I am sure virtually all of the 30-year swap market includes collateral posting agreements to maintain credit standards. So all you have to depend on with your 30-year swaps is that your counterparty will actually post collateral when they have to (the mechanism by which AIG counterparties got so many tens of billions of bailout dollars).
Since I’m not convinced, I’m proposing a contest.
‘Splain it to us dummies: Why do 30-year Dollar Swaps yield less than 30-year Dollar Treasury Bonds?
Please attach your theory in the form of a comment, or, if you’d like, as a Blowback private e-mail. Extra points for humor and originality.
First prize, for best rational explanation, is a guest column at MindOnMoney (if you want it). The best humor/off the wall explanation will also be awarded a guest column, again at the sole discretion of the entrant.