BNZ Currency Research [New Zealand 24-5-2011]5054

8/6/2019 BNZ Currency Research [New Zealand 24-5-2011]5054

http://slidepdf.com/reader/full/bnz-currency-research-new-zealand-24-5-20115054 1/4

Interest Rate Research

24 May 2011

research.bnz.co.nz

-0.5

-0.3

-0.1

0.1

0.3

0.5

0.7

0.9

1.1

1.3

1.5

18/04/1996 18/04/1999 18/04/2002 18/04/2005 18/04/2008 18/04/2011

New Zealand 5 and 10 year swap-bond spreads

NZ 5-year swap spread

NZ 10-year swap spreadSource: Bloomberg

(%)

What’s Up With Swap Spreads? The unusual period of negative NZ swap-bonds

spreads appears to be coming to an end. We expect

positive swap spreads to be sustained and increase.

A more balanced supply to demand ratio for

Government bonds should see long bond yields

decline relative to swap yields.

A tight Budget should also limit further risk premium

being applied to long Government bond yields relative

to swap yields.

Some expected flattening in the yield curve, as interestrates rise should also be associated with a sustained

positive swap spread.

Positive swap spreads should see increased issuance

in areas such as S.S.A1 Kauri bonds where swap-

referenced yields will appear more attractive to

investors, relative to NZ Government bond yields.

Recently there have been some interesting developmentsin the relationship between NZ long bond and swapyields. In the last few weeks, swap-bond spreadshave returned to positive territory after almost a yearbelow zero.

Generally swap yields trade above bonds of similarmaturity. Over the past year or so, however, NZ swapyields have traded below bonds at the long end of thecurve (5, 7 and 10 year). This has been an aberration in the15 year history of NZ swap spreads and is also unusual ona global basis.

A positive swap spread is the norm globally. Australianand German 10-year swap spreads have always been

1AAA rated Supranationals, Sovereigns and Agencies

-0.3

0

0.3

0.6

0.9

1.2

1.5

18/04/1996 18/04/1999 18/04/2002 18/04/2005 18/04/2008 18/04/2011

Global 10-year swap to bond spreads

AU 10-year swap spread

US 10-year swap spread

Germany 10-year swap spread

UK 10-year swap spreadSource: Bloomberg

positive. The UK and the US have experienced only veryshort-lived periods of negative 10-year swap spreadsin the last couple of years. At the very long end of thecurve (25-30 years), however, markets such as the USand UK have seen more prolonged periods of negativeswap spreads.

We will therefore attempt to answer four questions:

(i) Why does the swap spread matter?

(ii) What determines swap spreads over bonds?

(iii) What caused NZ swaps to trade below bonds andwhat drove the normalisation?

(iv) Where to with swap spreads from here?

(I) Why do swap spreads matter?

They matter to corporate, supranational and agencycredit issuers and their investors. These entities issuecredit with reference to swap rates. Investors comparethe attractiveness of these investments, relative toGovernment bonds, which can have greater liquidity andshould represent lower default risk.

The swap-bond spread is therefore critical in determiningthe relative attractiveness of fixed interest investments.In addition, some fixed income funds are benchmarkedto swaps making the swap spread critical to investmentdecisions.

They matter to sovereign debt issuers making decisionsaround whether to shorten the duration of public debtthrough engaging in swaps.

They matters to traders who hope to benefit fromtrading the spread, know as EFP (Exchange For Physical).i.e. A transaction in which one party buys the physicalcommodity (bond) and simultaneously sells the derivative(swap), and the other party does the opposite.



Currency Research 24 May 2011

www.research.bnz.co.nz

0

5

10

15

20

25

30

35

40

45

1/01/2000 1/01/2002 1/01/2004 1/01/2006 1/01/2008 1/01/2010

NZ Government bonds outstanding

NZ Government bonds outstandingSource: RBNZ

NZDbn

(II) What determines swap spread over bonds?

There is a swathe of financial literature as to why swapstheoretically trade above bonds and what determines thespread. Most of these concentrate on the US market, butrecurring themes are; 1/ Government bond supply issues

2/ relative credit risk inherent in the two instruments 3/ theslope of the yield curve.

1/ Government bond supply relative to demand hasthe potential to shift bond yields. Bonds have a scarcityor abundance factor which swaps do not. All elseequal, swap spreads should narrow when bondissuance increases.

2/ Relative credit risk. The risk of default for a bondlies with the credit-worthiness of the sovereign. Swapscontain an inherent risk of counterparty default. Ultimatelythe bank quoting the floating rate could default, althoughin recent years banks have put in place 2C.S.A.

agreements that reduce much of the credit risk.

3/ The shape of the yield curve. When the curve is steepthe demand to be a fixed rate receiver in a swapincreases. Hence a steeper yield curve could be expectedto be associated with tighter swap spreads.

Therefore if these findings hold, the spread betweenswaps and bonds would be expected to narrow whenbond supply increased, when perceived risk ofGovernment default relative to banks increased, andwhen the yield curve steepened.

(III) What caused NZ swap spreads to narrow tothe point of being negative?

First, the period of negative swap spreads has coincidedwith the meaningful pick-up in net debt issuance by theNZ Government. Total Government bonds outstandingbegan a steep ascent from the start of 2010, having beenfairly stable over the previous decade. Bonds outstandinghave almost doubled since late 2009, as the Government

2 Credit Support Annex

expanded its deficit during the recession. NZ 10-year bondyields moved below swap yields for the first time in March2010. They moved more convincingly into negativeterritory in July 2010.

Second, in addition to pure supply/demand dynamics therelated issue is perceived Government default riskassociated with a pick up in debt issuance. An increase inthe overall bonds outstanding incrementally raises the riskof holding those bonds. Hence an increased risk premiumis applied to the bond yield relative to the credit riskinherent in the swap yield.

An exaggerated example of the phenomena is Ireland.From 1996 to early 2008 Ireland’s sovereign 10-yearbonds showed a typical relationship, trading 20bp belowswaps on average. More recently as Ireland’s Governmentdebt issues have reached crisis point, 10-year bondyields have soared to around 10%, well above 10-year

swap rates at 3.4%. Irish swap spreads are thereforemassively negative.

While NZ Govt debt levels are far from Ireland’s a marginalincrease in perceived default risk has also been at play inthe NZ market.

-1.5

-1

-0.5

0

0.5

1

1.5

2

2.5-0.5

0

0.5

1

1.5

1/01/2000 1/01/2002 1/01/2004 1/01/2006 1/01/2008 1/01/2010

NZ 10-year swap spread vs yield curve

NZ 10-year swap spread

10 year swap minus 2 year swapSource: Bloomberg

Third, the recent decline in 10-year swap spreads intonegative territory has coincided with the steepening inthe yield curve to the steepest in history. As the OCRhas been slashed to the historically low level of 2.5% thecurve has steepened dramatically. Steeping in the yieldcurve has also been associated with the cyclical dips ofNZ GDP growth (qoq) into negative territory, and troughsin investor sentiment post the Christchurch earthquakes.

Expressing the view that the RBNZ will cut rates/staylower for longer can be done effectively through swapswithout the upfront cost of purchasing bonds. Swaps aretherefore a more leveraged way (with greater liquidity inthe context of the NZ market) of expressing negativeeconomic sentiment. Participants are motivated to receivehigh fixed rates while paying low current floating ratesthrough swaps. Hence swap yields fell further and morerapidly than bond yields.



Currency Research 24 May 2011

www.research.bnz.co.nz

-1.5

-1

-0.5

0

0.5

1

1.5

2

2.5

3

30 /06 /1996 30 /06 /1998 30 /06 /2000 30 /06 /2002 30 /06 /2004 30 /06 /2006 30 /06 /2008 30 /06 /2010

NZ GDP

NZ GDP (qoq %)Source: Bloomberg

In summary, the recent decline in NZ swap spreads tonegative territory was driven by a combination of a pick-upin Govt debt issuance, marginal increase in Govt defaultrisk, and severe steepening in the yield curve. The NZswaps and bond markets are also in some ways quite

separate with different customer/investor bases,responding to different demand/supply dynamics. Theability to engage in a relative value trade (EFP), across thetwo markets, though theoretically possible, is moredifficult in practise. Cross market anomalies can thereforepersist for some time.

What drove the normalisation?

0%

200%

400%

600%

800%

1000%

1200%

15/01/2009 15/07/2009 15/01/2010 15/07/2010 15/01/2011

Bid-to-cover at NZ bond auctions

Bid-to-cover ratio (%)

Source: NZ DMO

While Government bond issuance has continued apace,in recent weeks there was a spike in demand relative tosupply. This brought to an end a period of below averagebid-to-cover ratios at auction that had endured since early2010. The low demand relative to supply spanned the

period of negative swap spreads.

The recent spike up in demand may partly be attributableto a broadened investor base. Anecdotal evidencesuggests that some recent demand for NZ Governmentbonds may have come from areas such as Asiansovereign wealth funds, diversifying their holdings.

In addition, the curve has also flattened slightly in thepast few weeks, coinciding with the move in swapspreads back to positive territory. The 2s-10s swap curvehas flattened from a peak of 2.14% in mid April to closeto 1.9% now.

(IV) Where to with swap spreads from here?

We turn to the three recent drivers of the swap spread.

First, the spike in recent weeks in the bid-to-cover ratiofor NZ bonds is unlikely to be sustained. (indeed in last

week’s auction much lower levels were achieved).However, the Government has recently built up cashbalances through pre-funding. In the 2011/12 Budget ithas also announced a gradual reduction in gross bondissuance over the next few years from 13.5bn in 2011/12to 8bn in 2014/15. This will mean net bond issuance ofjust 5.9bn in the coming fiscal year.

We therefore believe demand relative to supply is likelyto move back to more ‘normal’ levels. During the periodof negative swap spreads of the past year, the averagebid-to cover ratio was a relatively low 2.8x. The averageratio from 1983 is around 3.2x, and we would expect tomove back toward these levels.

Second, a tighter Budget may also limit any furtherincrease in default risk premium being applied to NZlong bond yields relative to swap yields. With the releaseof the Budget, rating agency S&P confirmed their currentsovereign rating of NZ. However, they have kept NZ’sforeign currency rating on ‘negative watch’, with the riskof downgrade if NZ’s external position does not improve.Rating agency Fitch described NZ’s Budget asappropriate, while Moody’s said NZ’s Budget supportsa path to surplus and reiterated their AAA rating.

Finally, we expect economic sentiment to graduallyimprove and the market to factor in a removal of highly

accommodative monetary policy. We expect that oncethe RBNZ gets underway they will move steadily towarda 5% peak in the OCR. In line with this view, we anticipatesome flattening in the curve from current historicallysteep levels.

Strategy implications

Therefore, we expect that long end swap-bonds spreadswill move in the direction of more ‘normal’ levels. The 15-year average is around 60bp but does disguise somemarked trends. In addition, the proliferation of C.S.Aagreements, post the Global Financial Crisis, that help tomitigate counterparty risk, may also mean that long-termaverage swap spreads have shifted lower. However, given

the three key drivers, discussed above, are all moving inthe same direction, we expect swap spreads to remainpositive and move gradually higher in the year ahead.

This should see increased issuance in areas such as Kauribonds by AAA rated Supranationals, Sovereigns andAgencies, as their swap-referenced yields will appearmore attractive to investors relative to NZ Governmentbond yields.

Borrowers should also consider the risk of higher swaprates as interest rates rise and swap spreads relative tobonds likely increase.

[email protected]

BNZ Currency Research [New Zealand 24-5-2011]5054

Documents

Transcript of BNZ Currency Research [New Zealand 24-5-2011]5054