By Kirsten Donovan
LONDON (Reuters) - Bets that euro zone interest rates will stay low for a long time and falling risk assets on worry over fiscal stability have seen pension funds seeking longer- dated fixed income cash flows, driving 30-year swap rates down.
Funds have been seeking to receive 30-year fixed rate payments in the interest rate swaps market to match their long-term liabilities.
That has compressed the spread between 10-year and 30-year swap rates since last Friday by more than 20 basis points to its tightest since mid-2009.
Although some of that was given back on Tuesday, it remains around 10 basis points flatter over the period at around 30 basis points.
An agreement in the swap market between two counterparties involves the exchange of a stream of a fixed payment for a floating payment linked to an interest rate, usually Libor.
Some analysts compared the magnitude of the recent move to that seen in the wake of the collapse of Lehman Brothers in 2008, when the curve inverted.
"While the current move is less severe, it is happening against a backdrop of equity market weakness and lower term structure rates, both of which hurt pension fund cover rates," said ING rate strategist Padhraic Garvey.
"Bottom line, the latest 10/30 year flattening process is pushing against an open door for as long as the current theme of lower market rates and weak equity markets continue." As assets such as equities and higher-yielding euro zone government bonds fall, the value of a pension fund's assets decreases.
At the same time, if interest rates are falling, or expectations are that rates will stay lower for longer than anticipated, the present value of the fund's liabilities will increase, lowering the fund's cover rate.
Thirty-year government bonds, which also offer long-term fixed cashflows, have outperformed their 10-year counterparts too. But swaps offer a less capital intensive way of securing long-term cash flows because they are off balance sheet and no outlay is necessary to buy an underlying asset.
SHORT GAMMA
Credit Agricole CIB strategist David Keeble said the recent receiving flows appear to have been exacerbated by swaption traders who have short gamma -- a change in the sensitivity to the underlying asset's price -- positions, needing to receive 30-year swaps the more the rate declines.
Keeble said the moves may be so extreme because of fear of what occurred in the second half of 2008, when 30-year swap liquidity dried up making it extremely difficult for dealers to execute trades.
"Perhaps one difference between then and now is that in 2008 the 30-10 year spread was also moving rapidly in the U.S. and UK. It was a global phenomenon, whereas the movement in recent days is quite Euro-specific. Whilst the U.S. 30-10 year spread is stable, we think that the movement in Europe could easily peter out," he said.
Thirty-year swap rates remain below the equivalent German Bund yields by some 15 basis points. Although this has been the case since early 2009, it is abnormal as a swap agreement carries counterparty credit risk.
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Last updated: 09 February 2010, 14:16
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