Morgan Stanley: inverted swap spreads will alter pension fund hedging

The UK 30-year gilt rate has been higher than its swap equivilant since mid-2008 and while the spread has shrunk from its 150-basis-point peak it still stands at about 50bp, according to data from Morgan Stanley. This is a reversal of pre-crisis market norms and inverted spreads are generally regarded as anomalous due to the lower credit risk associated with government debt.

But Laurence Mutkin, senior European interest rate strategist at Morgan Stanley, disagrees. He argued inverted spreads were a reflection of investors' reluctance to surrender assets upfront without compensation – a concept he referred to as "balance sheet rent" – rather than a sign of dislocated markets. Mutkin said the lower upfront capital requirements of swaps meant they are priced more competitively than government paper at present.

Mutkin said inverted spreads indicate increased confidence in swap contracts by investors. "When swaps first appeared in the 1980s, they may have presented counterparty risk, but they are now fully collateralised and often traded through central counterparties, so this risk is not very different from government bonds. The difference is that the effect on the balance sheet of a swap is negligible, whereas with a bond there is a considerable initial cash outlay – and this comes at a premium," he said.

The clear result of the inverted spread, according to Mutkin, is that it will prompt insurers and pension funds to change their duration hedging strategy away from swaps towards government bonds. The flipside of this trend is that these organisations will shift their risky asset investments into synthetic form – so rather than buy equities they will purchase synthetic derivatives such as futures.

"A lot of [insurers had] hedged fixed-income liabilities with swaps rather than with cash bonds. They could now choose to switch, to lock in implicitly the underperformance of bonds versus swaps. Previously, government yields have been too low to fund their liabilities, so they needed to try to generate alpha in risky assets to help make up the shortfall. As government bond yields rise versus swaps, though, their model may shift to matching their liabilities with cash assets and seeking alpha synthetically."

Balance-sheet rent is a controversial idea, and still not universally accepted – Mutkin noted that there had been some scepticism in the market reaction to his report on the subject, Raising the rent of balance sheet. But he says this was because the charge had effectively been zero or even negative in the pre-crisis credit boom environment, and that it would remain a factor until confidence returns in the financial sector.

"While investors remain wary of committing balance sheet while governments need a lot of funding, upward pressure on bond yields relative to swap rates will persist. When will long-maturity government bond yields trade below swap rates again? If the argument is right that balance sheet was fundamentally underpriced during the credit bubble, the implication is that long-maturity government yields will only trade below swap rates again if the credit bubble returns – not a likely scenario."

An in-depth anaylsis of inverted swap spreads will appear in May's Life & Pension Risk.