Swaps Become Preferred Hedge in US Credit Markets
The credit spread—the portion of a bond’s yield above the risk-free rate that compensates investors for default risk—can vary significantly depending on the benchmark used. This divergence has emerged as a notable feature in US credit markets, where bonds from issuers with identical seniority, ratings, and credit risk trade at markedly different spreads when measured against government bonds versus interest rate swaps.
A Dislocation Between Bonds and Swaps
In strategies designed to isolate credit risk while hedging interest rate exposure, the choice of hedging instrument directly impacts realized value. Alphabet, the AA-rated parent of Google, exemplifies this dynamic. At the 20-year point, the company’s bonds yield approximately 90 basis points over US Treasuries, a level that appears expensive given the issuer’s high credit quality. However, when measured against interest rate swaps, the same bonds offer around 150 basis points in compensation. The underlying bond yield remains unchanged, but the comparison benchmark shifts the perceived risk-reward balance dramatically.
This phenomenon is not isolated to Alphabet. Across the US market, similar discrepancies exist, prompting a reevaluation of duration-hedging approaches in credit-only strategies. The traditional use of Treasury futures for hedging dollar duration may no longer capture the most favorable risk-adjusted returns in the current environment.
Read Also: Book traces debt’s evolution from warships to the Fed
Choosing the Right Hedge
The decision hinges on selecting the more accurate proxy for the risk-free rate. While Treasury futures are the conventional choice, the swap curve currently better reflects the dollar risk-free rate. This shift stems from negative swap spreads, where swap rates trade below government bonds of the same maturity, which invert the typical relationship between safe borrowers and bank-based rates. Persistent budget deficits and rising Treasury supply have driven government yields higher, particularly along the longer curve, creating distortions that favor swaps as a hedging tool.
In August, funds replaced part of their US Treasury futures duration hedge with interest rate swaps for the long dollar curve. By hedging with swaps instead of Treasuries, the retained spread over swaps became the relevant metric. For example, Alphabet’s euro-denominated bond traded at roughly 110 basis points over German government bonds, while the dollar bond showed 100 basis points over Treasuries. However, once the dollar bond was hedged back using swaps, the effective spread rose to approximately 170 basis points, making the dollar bond more attractive despite superficial appearances.
Risks and Rewards of the Swap Strategy
Historical data highlights the unusual nature of today’s swap spreads. Before the financial crisis, 10-year swap spreads averaged around 60 basis points. Today, they sit near -40 for 10-year and -70 for 30-year maturities, well beyond post-2008 norms even after adjusting for the transition from LIBOR to SOFR. At these levels, further widening appears less likely than a gradual normalization toward zero, according to the analysis.
