Spreads on interest rate swaps have widened dramatically in recent weeks, providing an unexpected boost to big bank trading operations.
Swap dealers attribute the rise to 33.75 basis points, from 24, to a drop in federal government borrowing combined with undiminished investor demand for fixed-rate U.S. Treasuries.
Spreads on interest rate swaps reflect the difference between the three- month London interbank offered rate and the yield of fixed-rate Treasuries.
Wider spreads have created strong demand for trading services because they encourage investors to buy fixed-rate instruments, swap the fixed-rate for floating, and profit from the spread.
Banks that historically have done big business in interest rate swaps include J.P. Morgan, Chase Manhattan, Citibank, Bankers Trust, Bank of America, and NationsBank.
Traders say the rise in interest rate swap spreads began earlier this year but really took off about three weeks ago.
They attribute the rise in the swap spread to the flattening yield curve for Treasuries. Demand for Treasuries remains strong, but thanks to a strong economy the government has borrowed less.
"There's a lot of demand chasing very little debt issuance by the federal government," said Ernest Porchetta, vice president at CIBC Wood Gundy's swaps desk. "Just about every kind of debt from 10- year options to five-year repos is much less available than it once was."
In July the Treasury said it borrowed only $44.6 billion in the first quarter, compared with $77.2 billion a year earlier. A spokesman said the Treasury Department expects to continue borrowing less than originally forecast this year because tax receipts are unexpectedly high.
One consequence, at least in the short term, is a change in the funding strategies of some major banks and finance companies.
Last week companies such as First USA Inc., Chase Manhattan Corp., and MBNA Corp. issued billions of dollars worth of fixed-rate asset-backed securities to take advantage of the current market situation.
Normally these companies would issue floating-rate securities. But the rise in interest rate swap spreads has changed that. Now investors are motivated to buy fixed-rate securities and then swap for floating.
The banks get a cheap and steady source of funds by issuing fixed-rate securities and investors capture better yield than they get buying most corporate bonds, thanks to the high spreads in interest rate swaps.
The impact of the rise in swap spreads is most pronounced in the credit card-backed securities market.
Ordinarily issuers such as First USA and Chase Manhattan prefer floating-rate securities, because the interest rates they charge credit card customers frequently change.
The wider spreads have brought unexpected action to the swap desks at major trading banks, which earn fees for completing transaction for issuers and investors. Traders say the activity has revived profit margins that had become razor-thin six months ago.
"A little while ago it was tough to make money because spreads were so tight," said one trader. "But now they're eight to 10 basis points higher on the long end, and 12 points for two-year deals. You sure can capture a lot more than you used to."
Although no one is sure how long spreads will remain wide, there is agreement as to what could rein them in: a rise in interest rates.
"If that were to happen, spreads could come in because companies would start issuing floating-rate debt again," said Mark Hernandez, vice president for Latin American swaps at J.P. Morgan & Co.