Definitions :
UST10YY = Yield on 10 year US Treasury Note = Interest rate at which the US Government can borrow for 10 years
USD10YSR = 10 year swap rate = Good proxy for interest rate at which good quality corporates can borrow USD from the interbank market for 10 years (ignoring fixed/floating, on-/off-balance sheet, etc)
US10YBSS (US10 year bond swap spread) = USD10YSR minus UST10YY
On 30Mar2008 : USD10YSR = 4.08% UST10YY = 3.45%
Thus US10YBSS = 4.08%-3.45% = +63 bp (normal, pre-TARP et al)
Today 26Mar2010 : USD10YSR = 3.78% UST10YY = 3.86%
Thus US10YBSS = 3.78% - 3.86% = -8 bp (unusual)
Intuitively, it should be obvious that normally, the BSS should be a positive number, ie the US government should (almost) always be able to borrow cheaper than a US corporate. During my years as an interbank trader, it was conventional wisdom that negative BSS cannot persist for long and it will always go back to positive. Thus, every time it went negative anywhere, you would earn positive carry by buying the government bonds (earning UST10YY) and paying the swap (borrowing cost USD10YSR) and clean up when thing normalized. A no brainer trade in most cases.This time, however, I think it really is different and to expect the US BSS to go back to positive anytime soon would be a bridge too far. The reason for this big move (see chart) is well explained by Bill Gross : "Government bailouts and guarantees such as those evidenced and envisioned in Dubai and Greece, as well as those for the last 18 months with banks and large industrial corporations across the globe, suggest a more homogeneous “unicredit” type of bond market. If core sovereigns such as the U.S., Germany, U.K., and Japan “absorb” more and more credit risk, then the credit spreads and yields of these sovereigns should look more and more like the markets that they guarantee."
In other words, Uncle Sam's (USA) balance sheet has been impaired by all the garbage assets taken over from the banks in trouble. It follows then, that conservative Uncle Warren (BRK), with his pristine balance sheet, should be able to borrow at a cheaper rate than Uncle Sam. Hence, negative BSS.
I have only encountered 2 previous occasions where BSS have gone negative. 1. Italy in the mid 90s when politics and government finances were a mess. LTCM made a hugely profitable bet that Italy would not default on its debt and eventually the negative BSS went back positive. 2. Singapore in 2003 (?). (Details hazy). Due to technical pressures on the short dated interbank markets, borrowing costs in SGD became prohibitively expensive. Banks needed to pay penalty rates to fund their SGS holdings (on balance sheet), resulting in heavy selling. The move in SGS rates higher were not matched by the swap market (off balance sheet). BSS went from +25/+30 to -6 and took a few professional traders (who got in too early in very large sizes) casualty along the way.
[Yours truly had the honor of putting on the SGD BSS at -5 back then]. Current SG10YBSS is around +18 vs US10YBSS at -8.
4 comments:
From my friend LTW :=
I cannot remember the exact year but think it was late 2002 to mid 2003 time when there were a lot of foreigners issuing SGD denominated bonds. Think it actually went negative somewhere mid 2003. The MAS rule at that time ( non-internationalisation of SGD ) foreigners must swap back the SGD into libor via X-ccy swaps. As a result, local banks were all paid SGD fixed agst libor. They hedged by receiving SGD fixed in the IRS. So there was this naturally need to rec SGD fixed. At that time, MAS continue with its issuamce calender despite the 'cheapness' of the the SGS. I cannot remember the actual date without the bloomberg. It was also that time that the basis swap was also out of whack and foreigners found it much cheaper to issue in SGD. That much i can recall. Does it sound reasonable?
Investor demand for SGS were minimal especially that SGD was on a depreciating trend and the bonds were being passed around like hot potatoes among the dealers... that would get your hands burnt. Being a primary dealer was more like doing National Service. Nowadays, SGS are in hot demand as SGD is on appreciating trend. Anyway, they are better alternatives to US Treasuries and Greek bonds.
Hi TS,
Thanks for spending time to explain that. It helped.
Many thanks.
:-)
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