treasury practice ASSET SWAPS

YOUR
FLEXIBLE
FRIEND?
ASSET SWAPS ARE A VALUABLE TOOL IN BRINGING
BOND ISSUERS AND INVESTORS TOGETHER. JOHN
WRAITH OF THE ROYAL BANK OF SCOTLAND LOOKS
AT SOME OF THE VARIED APPLICATIONS FOR ASSET
SWAPS.

T
he raison d’etre of the capital markets is to bring lender and FIGURE 1
borrower together in the most efficient way possible.
CASHFLOWS UNDER PAR PAR FLAT OF ACCRUED
Inevitably, the profile of borrowing required by a bond issuer
may not always exactly match the investment needs of the SINGLE CURRENCY ASSET SWAP.
lender. One of the financial instruments which is used to bridge this
gap is the interest rate swap. When combined with a cash asset
(liability) such as a bond in a structure which matches one leg of the
swap exactly with the cashflows on the asset (liability), a synthetic
instrument with a different profile from the original bond is created.
This synthetic combination is called an ‘asset swap’.
The asset swap has the effect of separating the ‘credit risk’
decision from the ‘market risk’ decision. An issuer can select the
capital market where his credit name will command the best pricing
regardless of whether he requires funding with the interest rate
profile or in the currency of the actual issuance. The investor likewise
can select a credit which he believes to be competitively priced and
then construct the asset profile to suit his portfolio. Thus an
understanding of the mechanics of the asset swap is essential for the
treasurer involved either in considering the options for bond issuance
or in managing investment portfolios within a bank treasury
department or as trustee of a company pension scheme.
The two following examples look at how an asset swap can be
constructed to change the interest rate profile of an asset either in
one currency or across currencies.

CONSTRUCTING THE SINGLE CURRENCY ASSET SWAP. In an

asset swap, cashflows accruing on the corporate bond are exactly
netted out in the swap, while the upfront investment is exactly the
same as the return of principal at maturity. This is achieved through ▪ assume price = 110/yield = 5%.
the par par flat of accrued methodology, and provides a highly ▪ assume swap rate to maturity date = 4.75% (annual).
transparent and efficient trade for the investor. By swapping out all ▪ assume we are half-way through an interest accrual period.
the fixed rate elements of the bond, the investor is left with a clean ▪ to keep the example simple, we will not take different day
spread over swaps (Libor), which can be used to evaluate the bond in counts/payment periods into account. Clearly, these will affect the
question relative to both the interbank market and other bonds of calculations in reality, but the principle is the same, as
similar quality and maturity. Such swaps are constructed as follows: demonstrated here.

▪ assume a bond with 10 years to maturity. The flows relating to this deal under the structure of a par par flat
▪ assume annual coupon = 6%. of accrued asset swap can be seen in Figure 1. This example

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 treasury practice ASSET SWAPS

illustrates how an asset swap can be used to generate a structure FIGURE 2

that allows the investor to assemble a very clean trade. The net
EXAMPLE STRUCTURE OF CROSS-CURRENCY ASSET
result of the above mechanism is that the investor will spend exactly
£20m today on which he will receive a return of Libor+25bp until
SWAP.
maturity, when his initial outlay will be returned to him. Assuming
he is funding the bond position at Libor flat, this leaves an overall
net return of 25bp a year. Assuming the spread does not move
and/or the bonds are held until maturity, this return will be constant
(assuming no default on the bonds) and can be used to easily
compare and contrast varying types and maturities of corporate
debt.
The risk to the investor (other than default risk) arises in the
situation where the swap spread at which the bond can be asset-
swapped moves against him. Should this spread (25bp) widen, the
investor will realise a mark-to-market loss which would be
crystallised were the position to be closed out before maturity.

USING THE CROSS-CURRENCY SWAP TO EXPAND THE ASSET

BASE AVAILABLE TO INVESTORS. For bond investors, cross-currency
swaps are another way of expanding the available asset base and
enhancing the efficiency of the underlying portfolio. Where interest
rate swaps, as explained, are used for switching one type of interest
flow for another, cross-currency swaps are used to switch interest
flows in one currency (which can be either fixed or floating) for
interest flows in another currency. For example, a fixed rate US
dollar corporate bond can be swapped to create a sterling floating
rate note (FRN) and so on.
One of the key advantages of this is to open up whole new classes
of issuer and bond type to an investor who may have no scope or
desire to hold the bonds in question in their currency of issue. Unlike ‘THIS DYNAMIC... IS TYPICAL OF
interest rate swaps, there is usually a physical exchange of notional
amounts at the start and end of the deal, which on the one hand PERIODS OF ECONOMIC
does imply considerably greater utilisation of credit lines with the
swap counterparty, but on the other ensures that there is absolutely SLOWDOWN, WHEN HIGHER
no currency risk incurred by the investor. The basic structure of such
a deal is as set out in Figure 2.
QUALITY DEBT WILL ALWAYS TEND
PORTFOLIO APPLICATIONS OF ASSET SWAPS. In addition to their
TO OUTPERFORM’
applications in increasing the flexibility of investment and issuance
profiles on a standalone bond, asset swaps are increasingly being to significant spread widening. The stipulations of the minimum
used to alter the profiles of whole investment portfolios through funding requirement (MFR) effectively caused this spread widening
their use in managing interest rate exposure either as part of a to be maintained and even magnified, as insatiable demand for gilts
consistent hedging strategy or in instances where the cash market in conflicted with falling supply. Only recently has the relationship
an asset is illiquid. begun to head to more normal levels, with the announcement that
FRS17 would lead to the replacement of the MFR and a relieving of
USING ASSET SWAPS TO PROTECT AGAINST ADVERSE MOVES IN the pressure on artificially low gilt yields.
CREDIT SPREADS. At one time, short gilt positions were often held The effect of this spread widening on investors who held
to manage interest rate risk positions on credit based bond corporate bonds against gilts was substantial losses, as sovereign
portfolios. This was on the basis that the gilt and corporate bond debt remorselessly outperformed company debt. Indeed, this
markets would move in parallel, leaving exposure only to the credit dynamic (while it was exaggerated by the events mentioned above)
spread of the corporate over government. The asset swap now offers is typical of periods of economic slowdown, when higher quality
an alternative hedging mechanism which is arguably more robust in debt will always tend to outperform. In suggesting swaps as an
an environment where there is increasing volatility in the alternative hedge, it is important to investigate the performance of
relationship between spreads in corporate and sovereign debt. asset swaps at such times. If the relationship is more stable (that is,
As the interest rate swap market has matured over the past spread widening either does not occur or is more limited), then it
decade, so the relationship swap rates have with corporate debt follows that swaps are a better hedge for corporate bonds than are
yields has stabilised, while at the same time various events have Government bonds in a time of economic hardship. Figure 3 plots
contrived to break down the correlation between sovereign and the yield spread for generic 10-year AAA corporate debt against the
corporate bond yields. In particular, the Russian and Latin American relevant hedge instruments in the turbulent period from the
crises of 1998, exacerbated by the collapse of LTCM, led to high beginning of 1998 until the present. We can draw the conclusion
volatility in spreads as safe haven flows and credit deterioration led from this chart that gilts are not a well correlated hedge for

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 treasury practice ASSET SWAPS

corporate bonds at times when investors fear a rise in yields is FIGURE 3

imminent. The lack of stability in the yield spread between
10Y AAA CREDIT SPREAD V GILTS/SWAPS 1998-2001.
Government and corporate debt means there is no certainty that an
opposite position in gilts will offset an adverse move in corporate
debt. Indeed, it is possible that any loss could even be increased, as it
is conceivable that gilts may even move in the opposite direction
(negative correlation).

USING ASSET SWAPS TO PROTECT AGAINST ADVERSE

MOVEMENT IN OUTRIGHT YIELD. As an alternative, investors can
use asset swaps to cushion their portfolios from the adverse impact of
rising yields on outright holdings of bonds. By paying away the
coupons in the method described above (the par par flat of accrued
swap), the owner of the bonds is protected against a rise in yields as
long as the Libor spread at which the bonds are swapped does not
widen. Figure 4 demonstrates clearly that in recent periods of rising
yields, asset swaps have provided this protection efficiently. The
conclusion can therefore be drawn that asset swapping fixed interest
corporate bonds and holding them in synthetic floating form through
a period of rising outright yields protects the investor from losing
money on his portfolio. FIGURE 4
In Figure 4 for the period from 1 January 1999 to 31 December 10Y £ AA BONDS – YIELD AND SWAP SPREAD
1999, the generic AA-rated 10-year bond yield rose from 5.39% to 1998-2002.
6.55% (116bp), while asset swap spreads on generic AA-rated 10-year
debt moved from Libor+7bp to Libor+6bp. This shows how efficient
such a hedge can be – asset-swapping bonds for the whole of 1999
would have insulated investors completely from a major adverse
move in yields. Figure 4 illustrates the usefulness of the interest rate
swaps market in protecting bond portfolios against adverse moves in
bond yields. It can also be shown that the correlation between
corporate bonds and swaps is better than that between corporate
bonds and Gilts. In the eight years since the beginning of 1993, for
example, the spread of generic 10-year AAA bond yields over gilts has
traded in a range from 9bp to 121bp (a total of 112bp), while the
asset swap spread range has been -33bp to 41bp (a total of 74bp).
This evidence that swaps represent a more stable hedge than gilts for
corporate debt increases the attractiveness of interest rate swaps as a
stable hedge for bonds in periods of rising yields.

DURATION MANAGEMENT USING INTEREST RATE SWAPS. years) and buying six-month paper with the proceeds (receiving fixed
Interest rate swaps can also be used effectively to alter the duration for six months).
of a bond portfolio without physical reallocation of assets. At times of
increased volatility or other market uncertainty, it is appropriate to EFFICIENCY AND FLEXIBILITY. The utilisation of asset swaps can
shorten the overall duration of portfolios, as this will limit the scale of facilitate the efficiency and flexibility of the fixed income capital
losses should they arise. The shorter the duration of a bond (or markets by:
portfolio of bonds), the less the net present value of that bond (or
portfolio) will change per basis point change in yield. Therefore, at the ▪ allowing treasurers to issue securities based on credit pricing,
times of greatest uncertainty in financial markets, assets are generally irrespective of the interest rate risk profile or currency of the funds
reallocated to shorter maturities to protect the investor against more required;
significant losses. ▪ allowing investors to purchase bonds based on a credit decision,
Unfortunately, high volatility and rising yields also tend to mean regardless of the interest rate risk profile or currency which they
reduced liquidity, making asset reallocation a potentially expensive require;
business, as the investor is forced to cross wide bid-offer spreads to ▪ allowing investors to separate credit risk exposure from interest rate
switch holdings. A solution to this is presented by interest rate swaps, exposure on an investment or portfolio by locking into a ‘credit spread’
where positions can be established quickly and simply in instruments more effectively than is possible using gilt hedging techniques; and
where the bid-offer spread stays relatively tight, even in volatile ▪ allowing investors to change the interest rate profile of their portfolio
markets. By entering into an interest rate swap to pay fixed for, say, without disposing of assets in an possibly illiquid market.
10 years against receiving six month Libor, an investor can
immediately shorten the duration of his bond portfolio. From a risk John Wraith is Credit Strategist at The Royal Bank of Scotland.
perspective, the effect of entering into such a deal is the same as [email protected]
would be achieved by selling 10-year bonds (paying fixed for 10 www.rbsmarkets.com

MAY 2002 THE TREASURER 25