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Swap Spread: Why the 30-Year IRS Trades Below Treasuries
A swap spread is the difference between the fixed rate on an interest rate swap and the yield on a Treasury bond of the same maturity. It is a key gauge of bank balance-sheet capacity and funding stress.
Key Takeaways
- Swap spread equals the swap rate minus the same-maturity Treasury yield; the 30-year USD swap spread has been persistently negative since the post-2008 period, currently around minus 40 basis points.
- Negative long-end spreads reflect post-crisis regulations (Supplementary Leverage Ratio) that make holding Treasuries on bank balance sheets expensive, preventing the arbitrage that would close the spread.
- Pension funds and insurers structurally receive fixed in long-dated swaps to match liabilities, pushing swap rates below Treasury yields, a demand effect that is separate from any credit concern.
- Treating swap spreads as a clean arbitrage opportunity is incorrect; once balance-sheet charges, repo costs, and initial margin are loaded in, the apparent 40-bp carry can turn negative.
Key Takeaways
- Swap spread equals the swap rate minus the same-maturity Treasury yield; the 30-year USD swap spread has been persistently negative since the post-2008 period, currently around minus 40 basis points.
- Negative long-end spreads reflect post-crisis regulations (Supplementary Leverage Ratio) that make holding Treasuries on bank balance sheets expensive, preventing the arbitrage that would close the spread.
- Pension funds and insurers structurally receive fixed in long-dated swaps to match liabilities, pushing swap rates below Treasury yields, a demand effect that is separate from any credit concern.
- Treating swap spreads as a clean arbitrage opportunity is incorrect; once balance-sheet charges, repo costs, and initial margin are loaded in, the apparent 40-bp carry can turn negative.
What It Is
For a given tenor, the swap spread equals:
swap spread = swap rate - Treasury yield (same maturity)
Before 2008, swap spreads were reliably positive. A bank counterparty paying fixed on a swap was a less safe cash flow than the US Treasury, so the swap rate had to offer a premium. The textbook ordering was Treasury yield < swap rate.
Since 2008, long-maturity swap spreads in USD have frequently been negative. The 30-year swap has traded below the 30-year Treasury yield for most of the post-crisis period. This inverted the theoretical relationship and made swap spreads a regularly discussed topic in fixed-income circles.
The Intuition
On paper, receiving the Treasury yield and paying the swap rate should produce a risk-free spread, as long as you can fund the Treasury purchase at the overnight rate. If the spread is positive, the trade earns carry. If the spread is negative, the trade loses carry, which should trigger arbitrage until the spread turns positive again.
The arbitrage has not closed for more than a decade. The reason is that the trade requires a bank balance sheet to own the Treasury, and post-crisis rules (leverage ratio, liquidity coverage ratio, supplementary leverage ratio) make that balance sheet expensive. Meanwhile, pension funds and insurers have a structural need to receive fixed in swaps to hedge long-dated liabilities. Their demand pushes swap rates down. With no cheap way to arbitrage, the spread stays negative.
How It Works
To quote a 10-year USD swap spread, take the 10-year SOFR swap rate and subtract the 10-year on-the-run Treasury yield on the same day, using matched day counts and settlement conventions. The spread changes minute by minute as rates in each market move.
Drivers include:
- Balance-sheet cost. Post-crisis regulations penalize Treasury holdings through the Supplementary Leverage Ratio, making dealer balance sheets a scarce resource. More binding rules widen the gap.
- Duration demand from pensions and insurers. Underfunded pension plans need long-dated fixed cash flows. They express that need by receiving fixed in swaps, pushing swap rates lower relative to Treasuries.
- Treasury supply. Heavy Treasury issuance raises Treasury yields relative to swap rates, tending to widen the Treasury-rich anomaly (a more negative swap spread).
- Repo rate dynamics. The cost of financing a Treasury purchase in the repo market feeds directly into the economics of the swap-spread arbitrage.
Worked Example
Suppose the on-the-run 30-year Treasury yields 4.50 percent and the 30-year SOFR swap rate is 4.10 percent. The 30-year swap spread is:
4.10% - 4.50% = -0.40% (or -40 basis points)
An arbitrageur sees this and considers receiving fixed on the 30-year swap while shorting the 30-year Treasury. On paper, they earn the Treasury yield (minus repo) and pay the lower swap rate, locking in 40bp of carry.
In practice:
- Shorting the Treasury requires borrowing it through reverse repo, which ties up balance sheet and incurs specialness when the bond is hard to borrow.
- Receiving fixed in the cleared swap requires posting initial margin at a CCP.
- Under the Supplementary Leverage Ratio, the total gross position inflates the bank's balance sheet, consuming capital.
- All-in, the 40bp of apparent carry can evaporate or even turn negative once true costs are loaded in.
This explains why the spread has stayed negative. The arbitrage is not free; the costs have repriced.
Common Mistakes
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Assuming positive spreads imply bank credit risk alone. The pre-2008 mental model attributed the entire swap spread to the credit risk of bank counterparties in LIBOR. That interpretation broke when counterparties became central clearing houses and LIBOR was replaced by SOFR. Today the spread is about regulation and demand, not credit.
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Treating the spread as a clean arbitrage. Plenty of books still describe swap spread trades as "riskless carry." They are not. Financing costs, balance-sheet charges, and repo specialness can make the trade unprofitable on a fully loaded basis.
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Using LIBOR-based swap spreads post-2022. Almost all USD swap activity has transitioned to SOFR. Quoting a swap spread against legacy LIBOR curves mixes apples and oranges.
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Comparing spreads across currencies without adjusting for basis. A USD 30-year swap spread and a EUR 30-year swap spread are not directly comparable. The currencies have different curve shapes, basis adjustments, and regulatory regimes.
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Ignoring the on-the-run versus off-the-run distinction. Swap spreads are usually quoted against the most recently issued (on-the-run) Treasury, which trades rich relative to older issues because of liquidity premium. Using an off-the-run benchmark changes the spread.
Frequently Asked Questions
Q: What is a swap spread in simple terms? A swap spread is the difference between the fixed rate on an interest rate swap and the yield on a US Treasury bond of the same maturity. A positive spread means swaps cost more than Treasuries; a negative spread, which has been the norm in long maturities since 2008, means the opposite, an anomaly driven by regulation and structural demand.
Q: How does the swap spread affect investment decisions? Fixed-income portfolio managers use swap spreads to gauge market stress and bank balance-sheet capacity. Widening positive spreads historically signaled financial system stress. Today, very negative long-end spreads indicate structural demand for fixed cash flows from pension funds that outweighs any supply-side force.
Q: What is a real-world example of swap spread? The 30-year US Treasury yields 4.50% and the 30-year SOFR swap rate is 4.10%, a swap spread of minus 40 basis points. An apparent arbitrage of receiving fixed in the swap and shorting the Treasury looks attractive on paper, but Supplementary Leverage Ratio charges and repo costs eliminate the carry when properly accounted for.
Q: How can investors use swap spreads to assess market conditions? A rapid move toward more negative swap spreads at the long end suggests that pension liability-matching demand is overwhelming balance-sheet capacity, tightening the financial system's plumbing. Spread widening (toward zero or positive) during stress periods can signal dealer balance-sheet stress and is a useful complementary indicator alongside credit spreads and repo rates.
Q: How is a swap spread different from a credit spread? A credit spread measures the extra yield on a corporate bond over a comparable Treasury, it reflects default risk. A swap spread measures the difference between an IRS fixed rate and a Treasury yield, it reflects regulation, balance-sheet costs, and structural demand for duration, with almost no direct credit-risk component in modern cleared swap markets.
Sources
- Klingler, S. and Sundaresan, S. "An Explanation of Negative Swap Spreads: Demand for Duration from Underfunded Pension Plans." BIS Working Paper No 705. https://www.bis.org/publ/work705.pdf
- Boyarchenko, N., Gupta, P., Steele, N., Yen, J. "Negative Swap Spreads." Federal Reserve Bank of New York Economic Policy Review, 2018. https://www.newyorkfed.org/medialibrary/media/research/epr/2018/epr_2018_negative-swap-spreads_boyarchenko.pdf
- Kamakura Corporation. "Why is the 30-Year Swap Spread to Treasuries Negative?" https://www.kamakuraco.com/why-is-the-30-year-swap-spread-to-treasuries-negative/
Disclaimer
This article is educational content only and is not financial advice. Nothing here is a recommendation to buy, sell, or hold any security. Consult a licensed advisor before making investment decisions.