Why Bond Issuance drives swap market flows

Bond issuance is the most transparent driver of flows in the swap market.

Every new bond comes with a known notional, tenor, currency and start date -and in most cases, an associated swap that transforms fixed-rate issuance into floating-rate funding. During “issuance season”, these flows dominate activity across swap markets.

A quick look at the daily BondBlox email makes this obvious. On any given day, dozens of bonds price across financials, agencies and SSAs – the majority of which are swapped. This article explains how these bond prices are translated into swap pricing, how desks manage the associated risks, and the mechanics of pricing calls.

The list shown is not exhaustive – smaller MTNs and unrated issues won’t appear – but it gives a good flavour of what swap desks monitor.

What Swap Desks Look for in New Bond Issues

A quick scan of the list already tells us that:

• Financial issuers dominate the list. Swap desks generally assume that all financial issuance is swapped back to floating.
• BOC Aviation Ltd is an aircraft leasing company, whose lease income is floating – making a swap to floating the natural funding choice.
• The remaining names are mostly SSAs – Sovereigns, Supras and Agencies. Many of these swap their issuance too, unless they are issuing in their domestic currency (a statement with plenty of exceptions, but roughly correct).

About 75% of those deals are likely to have been swapped, equating to over $31bn of swap flows, 95% in USD.

This is why issuance matters. It is not theoretical flow – it’s real size with known tenors and dates.

Core Mechanics of a New Issuance Swap

There is nothing particularly exotic about a new issuance swap. The mechanics are straightforward:

• The bond issuer receives fixed, matching bond coupons from the swap counterparty with their payments due to bond holders.
• The fixed payments therefore match the bond coupons exactly – fixed rate, day-count convention, frequency and holiday calendars are all dictated by the terms of the bond.
• Swap dates are dictated by the bond. This typically means a T+5 start date, with maturities often in whole-year increments, though some issuers cluster maturities around reporting dates.
• The final intricacy – a bond issue may not be issued at “par” but the coupon payments are based on the full notional amount. This is the adopted convention so that bonds don’t have coupons like 4.14782%, but rather 4.125% and an issue price of 99.872. The difference in the coupons over the life of the bond is cash-settled upfront.
• As a result, the swap counterparty cannot solve for a fixed rate or an upfront payment. The only price they can quote is a spread to a floating index – typically SOFR in USD.

Translating Bond Price Guidance to a Swap Price

How does a swap dealer translate T+65bp into a spread over SOFR? This is where swap spreads come into play. Assume a 3Y USD bond with swap spreads at -15 basis points.

• The yield on the bond will be UST + 65bp. About 3.54% + 0.65% = 4.19%.
• But the swap spread markets equates a break-even swap (i.e. at SOFR flat) to UST -15bp. So about 3.39%.
• If we are trading a fixed rate of 4.19% on the new issue swap, we therefore have to take the difference of (4.19% – 3.39%) = 80bp on the Fixed side and convert on to the floating rate leg.
• This isn’t 1-for-1 because the 80bp is on an Act/Act semi-annual basis, whilst the floating leg of a SOFR swap is Annual Act/360.

Simple high-school maths is sufficient for indicative pricing and the daily pricing runs sent to DCM:

Where EAR is the Equivalent Annualised Rate, R is the number of basis points and n is the number of payments per year.

B2 and B1 are the denominators in the day count conventions – typically 360 or 365 (or 365.25 if you are being pernickity).

Finally;

In this case, 80 basis points equates to about 79.1 basis points on the SOFR leg.

At execution, swaps desk will fully discount all of the cashflows and solve to several decimal places.

How Swap Desks Price New Issuance: Step-by-Step

In practice, most desks follow a familiar process during issuance season.

The starting point is usually indicative pricing grids, requested by DCM colleagues on a Monday morning:

Maturity	$ Coupon	€ Coupon	£ Coupon	Swap to SOFR
3Y	T+65	MS+80	UKT+75	..
5Y	T+75	MS+92	UKT+80	..
7Y	T+85	MS+103	UKT+90	..

• The “known” inputs are where comparable issuers have recently printed; DCM then asks traders to translate these into an effective funding cost versus SOFR.
• Readers will notice that there are levels versus US Treasuries, EUR mid swaps and GBP UK Gilts. Maybe that was due to my experience at HSBC, it being a “global bank”, but it means there are many pricing variables at play:
  • Swap spreads, to convert the pricing levels relative to bonds in USD and GBP, back to USD floating rates (just as we looked at for bond futures).
  • Basis swaps in EUR to convert from EURIBOR swaps to €STR.
  • Cross currency basis in the case of EUR and GBP bond issues.
• These are just indications. The variability on the precise coupon will overwhelm any approximate swap pricing at this point in the process.

Swap Mandates and Risk Allocation in Bond Issuance

Once mandates are awarded, the swap typically follows.

The lead manager will usually have the first opportunity to quote on the swap, competing with other banks that have ISDAs in place with the issuer. Pricing reflects two distinct risks:

• Credit risk, which is rarely cleared on issuer-facing swaps.
• Market risk, which is the focus of this article.

These risks can be allocated in several ways:

• One counterparty takes both credit and market risk.
• Credit and market risk are separated across counterparties.
• One bank manages credit risk, while another manages market risk.

In practice, once separated, market risk itself is often fragmented by risk type – for example outright rates, basis or cross-currency exposure.

Pricing Calls

The swap does not need to be priced at the same time as the bond (which can help explain desk PnL as well). Separating the two reduces the number of counterparties involved at each stage.

As shown above, the counterparty will typically set-up:

• A swap pricing call. This will usually be done a week (or more) before the bond is issued, once investor appetite and bond pricing are firmed up.
• The issuer can then “lock-in” their cost of funds (relative to their floating rate of choice), knowing that e.g. T+65 will then always swap to USD SOFR + 79.1 bp, irrespective of what swap spreads do between now and when the bond is eventually launched.
• The issuer sacrifices potential upside if spreads tighten, but provides certainty over funding costs. This is the primary objective given that their funding target has been met.
• The swap counterparty/market risk managers now know 99% of the risks they are running, and will need to enter the market to hedge that risk.
• On the subsequent bond pricing call, the price of the bond relative to par will be set. This is where things become really market specific:
  • In USD and GBP, lead managers often pass USTs or Gilts to the swap counterparty, reflecting the fact that investors buy bonds “on spread”.
  • In EUR, this does not happen. Bonds may price versus mid-swaps, but the issuer does not provide the swaps that investors might hedge against.
  • This highlights a structural inefficiency in European capital markets: credit trades versus swaps, but duration is not mutualised through a common bond benchmark.
• The swap counterparty will either be the one “spotting” the bond, or the lead managers will and the swap counterparty will be a listen-in only participant. This should be straight-forward.
• The final terms of the swap will be finalised as soon after the bond pricing call as possible. Because the market levels of the inputs were already agreed a week ago, this should be a case of crossing T’s, dotting i’s and maybe some rounding in the dealers favour!

Just like DV01 and PnL, the mechanics are simple once you understand the conventions. Issuance season is like a map of where swap risk is about to land.

If you found this useful:
– DV01: the simplest way to understand swap risk
– Mapping DV01 across swaps, futures and bonds
– Where PnL really comes from on a swaps desk