Mechanics, market structure and the modern economics of swap spreads

Trading in Swap Spreads sheds light on new issuance flows (including spread locks), funding demand, term premiums, cost of balance sheet, capital allocation, liquidity, market infrastructure and sometimes even credit provision.

That a single instrument provides such rich insight into markets is great – and yet they don’t attract a whole lot of standalone commentary (aside from when they go negative).

In this blog I would like to explore what swap spreads really are, and tie that in with recent blogs on Spread Locks and New Issuance swaps.

Mechanics and Definition of Swap Spreads

In the USD interdealer market, swap spreads are commonly referred to as “Spreadovers.” USD may be the largest market, but I’ll stick with the more intuitive term swap spreads.

Definition

A pair of trades executed simultaneously incorporating a sovereign government bond and a swap in the same currency of the same maturity.

Simple enough – but the implementation varies significantly from market to market.

Mechanics and Market Conventions

Market	Bond	vs Swap	Price
USD Spreadovers	– On the run UST. – Benchmark maturity. – T+1 settlement. – Semi-Annual Act/Act DCC.	– SOFR OIS. – Closest benchmark maturity. – Spot starting. – Fixed Leg Annual Act/360 DCC. – Float Leg Annual Act/360 DCC.	$P(0,t1​)​=S(0,t1​)​−B(0,t1​)​$
EUR Futures-based Invoice Spreads (Schatz, Bund, Bobl, Buxl)	– Eurex German government bond futures. – Cheapest to deliver maturity. – Settlement date: 10th of the delivery month (i.e, 10th of Mar/Jun/Sep or Dec) – Annual Act/Act.	– €STR OIS. – Maturity date of CTD. – 10th of IMM month. – Fixed Leg Annual Act/Act DCC. – Float Leg Annual Act/360 DCC.	$P(IMM,t1​)​=S(IMM,t1​)​−B(IMM,t1​)​$
GBP Matched-maturity Swap Spreads	– Benchmark Gilt. – T+1 settlement. – Semi-Annual Act/Act.	– SONIA OIS. – Matched maturity to Gilt. – T+0 start date. – Fixed Leg Semi-Annual Act/Act. – Float Leg Annual Act/365	$P(0,t1​)​=S(0,t1​)​−B(0,t1​)​$

Why The Markets Look So Different

In my view;

• USD is the cleanest expression of a swap spread.
  A benchmark UST versus a spot-starting SOFR swap, each using the natural conventions of its liquidity pool.
• EUR is the most complex.
  A standardised futures invoice spread, with the swap engineered to replicate the CTD’s cashflows almost perfectly. Economically perfect – but arguably over-engineered for a liquidity transfer product.
• GBP sits in the middle.
  Gilts are issued less frequently, so matching the SONIA OIS maturity (and conventions) to the bond makes practical sense.

These conventions exist for structural reasons:

• USD trades this way because cash USTs are so liquid.
• EUR trades this way because Eurex Bund futures are far more liquid than cash bonds.
  (The “gadget” also trades – bund future vs spot starting 10 year €STR swaps).
• GBP trades this way because cash Gilts historically dominated liquidity, whilst futures liquidity (at ICE) is only in the 10 year part of the curve.

Trading: Throw The Old Strategies Away

A standard view on swap spreads spat out by many reference source and LLMs reads something like;

A swap spread is the difference between the fixed rate of an interest rate swap and the yield on a sovereign bond (like a Treasury) of the same maturity, representing the incremental premium demanded for taking on private-sector counterparty credit risk and liquidity risk over “risk-free” government debt

This standard definition of swap spreads, however, is now outdated and it is no longer how the market finds its equilibrium price.

So let’s move on from that – and explore funding and liquidity premiums instead.

What Swap Spreads Actually Represent Today

What do we now identify as the trading reasons behind swap spreads?

Consider USD.

USD swap spreads trade versus compounded SOFR – a rate derived from overnight repo transactions. So today’s USD swap spread is effectively:

UST yield vs compounded UST repo rates

In a frictionless world, that spread should be close to zero (just as covered interest parity suggests cross currency basis should be zero).

But swap spreads are clearly far from zero. They are also relatively volatile. Rather, much as in cross currency basis, funding and term premiums set the clearing price:

• It is expensive to tie up resources (funding/capital/balance-sheet) in a “risk free” asset like a cash bond. So cash USTs yield more than swaps to compensate for that cost.
• Cleared Swaps, on the other hand, are leveraged instruments. You only have to post a portion of the notional upfront as initial margin to the CCP. That is more efficient from a resource management perspective (funding/capital/balance-sheet).
• Does the market think that a CCP, with it’s pre-funded default fund, initial margin and daily variation margin represents a lower credit risk than the US government, who can print USD to repay USTs? Not sure honestly. Is it a component in setting the clearing price of USD Swap Spreads? Certainly.

Issuance, Flows and Swap Spreads

Liquidity is likely the single biggest driver of swap spreads. New issuance and pre-hedging (by way of spread locks) are the biggest determinant of the market price.

• Bond Issuers cannot use USTs to perfectly hedge their cash-flows.
• They hedge with swaps.
• More issuance -> more receiving in swaps -> selling of swap spreads -> swap spreads head negative.

The recent wave of AI-related infrastructure funding shows this in action. As an example, I imagine that Alphabet’s bumper issuance this month has translated into sustained swap spread pressure.

In Summary

The following is accurate;

A swap spread is the premium or discount required to exchange cash bonds for leveraged interest rate derivatives, representing imbalances in the supply and demand for those specific instruments caused by liquidity, funding and balance-sheet considerations.

It might not be catchy – but it’s true!

It aligns swap spreads with what they actually behave like:

• Funding instruments
• Flow-driven markets
• Cross currency basis trades

So stop talking about credit and swap spreads. They are a global capital allocation trade – and all the more useful for it.