The European Asset Swap Conundrum

We have experienced more than a decade of lower-for-longer rates induced by a combination of quantitative easing and strong forward guidance from the European Central Bank (ECB). Now, volatility is picking up in European rates after major central banks dropped forward guidance and expressed their will to be fully data dependent.

Inflationary pressures resulting from pandemic pent-up demand, supply chain disruptions and surging energy costs linked to the war in Ukraine have forced the ECB to end its net asset purchases in June and to frontload hikes, starting with a 50 basis point hike at the July meeting. Heightened volatility coupled with record low liquidity in European markets have created market distortions. For example, German bunds are pricing in more and more premium despite the ECB winding down its asset purchases program early, and despite more fiscal support for COVID-19 and energy relief measures.

The spread between German yields and the swap rate (bund spread) has reached historical highs, with the bund premium now higher post-QE than it was during the 2011 debt crisis. It is also higher than at the peak of the German collateral scarcity in 2016-2017, when QE was carried out within a restricted pool of eligible assets.

What are bond spreads and why are they used as a relative value trade?

Swap spreads combine a bond position with an interest rate swap duration hedge. Government bond spreads such as Bund asset swap (ASW) give the investor exposure to the difference between the yield of the German bund (cash or future) and the rate of the matched maturity swap, which can be used to express a view on the relative rich/cheapness of bunds versus swaps. An investor who thinks bund yields look rich against swap rates can enter into an ASW tightener (a short ASW position) by simultaneously selling bunds and receiving a matched maturity swap against it.

The main drivers of ASW spreads are government bond supply (the lower the supply, the larger the spread as a scarcity premium gets priced into government bonds), repo rates, risk-on/risk off dynamics and swap-specific flows.

Figure 1: Over a decade of ASW moves

Drivers of widening dynamics in 2022

Despite the ECB winding down its QE program and fiscal support from governments during COVID and the energy crisis, ASW spreads have defied market expectations and reached all-time highs. Several drivers have been behind the widening moves since the start of the year:

Flight to quality

Firstly, the Russia invasion of Ukraine and gas shortages have triggered a flight to quality as investors search for resilience in an uncertain macroeconomic environment, increasing demand for high-quality German bunds. This partly explains why German yields outperformed swaps in the selloff since the start of the year. While bund premiums have increased, it is important to note that other proxies for market stress (such as the spread between forward rate agreements and overnight indexed swaps – a measure of credit risk in the banking sector) have remained broadly contained. Moreover, the government bond premium versus swap hasn’t materialized as much in other jurisdictions (10-year German asset swaps have widened to a much larger extent than their equivalents in the U.K. and U.S.). This suggests it is a distortion due to the specific set-up in the eurozone, rather than any broader-based market stress building up.

Collateral scarcity/repo dynamics

Secondly, despite the ECB quickly reducing its German PEPP (pandemic emergency purchase programme) holdings as part of its reinvestment flexibility, a lot of collateral is still constrained (the free-float of German bunds is below 25%). This collateral is unlikely to be released any time soon, which explains why Schatz ASW (short-dated bund asset swaps) have been driving the move in the widening and why the ASW curve is now inverted. Figure 2 shows that demand for collateral via the ECB securities lending program increased significantly after the ECB raised its monthly lending limit from €75 billion to €150 billion at the end of 2021 in response to collateral shortages.

Figure 2: Monthly ECB securities lending rises steeply from end-2021

Bank asset/liability management (ALM)

Paying flows from bank ALM in a subdued liquidity environment have also largely contributed to spreads widening. Most European bank ALM (mainly German, French and Dutch) have negative convexity on the asset and the liability side of their balance sheets. This means that they have to sell duration when the market sells off, and buy duration when the market rallies. As they mostly hedge with swaps, this tends to push ASW wider in a selloff and tighter in a rally.

The sharp repricing of rates since the start of the year triggered a need to rebalance hedges on both sides of bank ALM balance sheets. On the asset side: Banks have to pay a fixed rate on swap to hedge duration on newly initiated mortgages. As mortgage applications have accelerated in anticipation of rising interest rates, banks had to initiate more swap-paying hedges (known as mortgage flow hedging). On top of the hedging of new mortgage flows, banks also had to increase the duration of their existing swap hedges as the probability of early repayment on current mortgages decreases when rates rise (known as stock hedging). On the liability side of their balance sheets, bank ALM had to pay a fixed rate on swaps to hedge the decrease in the duration of deposits: when rates go up, the average time cash stays on deposits at the bank decreases as higher-yielding assets offer better alternatives for investment.

Figure 3: Mortgage flows have increased sharply in expectation of rate rises, but are now starting to slow as affordability has decreased

Where from here?

As stated above, a multitude of factors have contributed to push ASW spreads to all-time highs, but there should be no structural reasons for levels to remain elevated. Shifting long-duration positions from German bonds to swaps looks attractive at these levels and would benefit from an ASW spread normalization over the medium term.

On the bond side, ECB QE came to an end in June and PEPP reinvestment flexibility over the June/July period showed a strong rebalancing out of core bonds towards periphery (mostly selling Germany versus buying Italy). This should help alleviate some of the German bunds scarcity over time. Germany is also likely to increase supply for energy support measures as it is the country most affected by gas shortages in Europe. Another measure that could potentially alleviate pressure on high-quality collateral would be if the ECB started issuing certificates of deposit to drain excess liquidity, as this would open access to the deposit facility to non-banks and provide high-quality collateral to market.

On the swap side, September issuance season usually sees a large amount of swapped issuance from corporate names, where the issuer simultaneously issues debt and receives matched maturity swaps to convert fixed coupons back to floating. This could help absorb some of the swaps paying flows from bank ALM.

Given that swap spreads are at all-time highs, we are also less likely to see offsetting flows from investors buying these new bonds on an ASW basis. The peak of euro-denominated swaps paying flows could also be behind us now that rates have repriced sharply higher (less new mortgages flows, and duration on existing mortgages has already vastly extended).

In order for swap spreads to materially tighten back however, some of the relief will probably need to come from the repurchase agreements (repo) market and easing of collateral shortages. With the ECB and DFA holding the largest share of outstanding bonds, the potential implementation of an RRP (reverse repurchase agreement) facility accessible to non-banks (on which the ECB recently released a working paper) could trigger a tightening and steepening of the ASW curve. But this would also depend on the Bundesbank softening credit limits with counterparties for the pass-through to materialize.

Market distortions offer potential for improved return for active managers

Higher volatility and record low liquidity in European markets have contributed to these market distortions on the asset swap curve. The widening of bund spreads to all-time highs is an opportunity for active managers to provide liquidity to the market and increase return potential by switching long-duration positions from German bonds to swaps.