What is an Asset Swap?
An asset swap combines a fixed-rate credit risk bond with a fixed floating interest rate swap, which transforms the bond into a synthetic floating rate note (FRN). The investor receives the relevant interbank benchmark plus a spread which is fixed at the initiation of the swap agreement and often bought by credit-focused investors such as hedge funds, mutual funds, and large financial institutions.
The spread depends on
- Difference between bond market price and its par value.
- Difference between bond coupon and the market swap rate.
Types of Asset Swaps Structure
There are two types, which are as follows.
#1 – Cross Currency Swap
It is a combination of bond purchases and currency swapsSwapsSwaps in finance involve a contract between two or more parties that involves exchanging cash flows based on a predetermined notional principal amount, including interest rate swaps, the exchange of floating rate interest with a fixed rate of interest.. It is a mixture of 3 components:
- Purchase of fixed-rate bonds
- Pay fixed IRS in the same currency as bond
- A currency basis swaps to pay foreign currency floating coupons and receive domestic currency floating coupons.
For e.g., investors may consider buying corporate bonds in a non-domestic currency and then transacting in currency swapCurrency SwapCurrency Swap is an agreement between the two parties for exchanging notional amount in one currency with that of another currency. It's interest rate can be fixed or floating rates denominated in two currencies. to create a synthetic domestic currency FRN.
If the resulting spread is superior to the spreads available from the same issuer’s domestic currency bonds/ FRN, it will result in profit.
#2 – Liability Swap
Bond investors use very similar, but opposite transactions to exploit anomalies that will provide the cheapest source of finance in domestic and international bonds and financial marketsFinancial MarketsThe term "financial market" refers to the marketplace where activities such as the creation and trading of various financial assets such as bonds, stocks, commodities, currencies, and derivatives take place. It provides a platform for sellers and buyers to interact and trade at a price determined by market forces., which are often described as liability swap. They are structured by corporate borrowers seeking to obtain the cheapest finance in domestic or international markets.
Example of Asset Swap
Let’s explain this by taking an example:
Blackrock fund borrows USD 10 million from a bank at a floating rate LIBOR+30 bps. It expects the interest rate to rise in the future resulting in an increase in borrowing costs, and wishes to hedge its exposure. Therefore, it enters into interest rate swapInterest Rate SwapAn interest rate swap is a deal between two parties on interest payments. The most common interest rate swap arrangement is when Party A agrees to make payments to Party B on a fixed interest rate, and Party B pays Party A on a floating interest rate. through a swap dealer wherein the fund receives a floating rate of LIBORLIBORLIBOR Rate (London Interbank Offer) is an estimated rate calculated by averaging out the current interest rate charged by prominent central banks in London as a benchmark rate for financial markets domestically and internationally, where it varies on a day-to-day basis inclined to specific market conditions. +50 bps and pays a fixed rate of 5% on a notional amount of 10 Million.
The net credit spread earned by the fund is 20bps (50 bps – 30 bps).
Motivation Behind these Swaps
Some of the important motivations for investors.
#1 – Leverage
Such investor typically looks for leveraged exposures source on a floating basis. The cost of funding borne by the investor is pivotal to asset swap transactions. The deal is usually compared to unfunded alternatives, such as the possibility of selling CDS protection on the same reference entity.
#2 – Credit Spread Opportunities
The main motivation behind taking exposure on a relative value basis is to achieve the target credit spread. Investors normally do not hold simple accrual product till maturity and often attempts to liquidate it by entering into an opposite transaction with exact similar terms as the previous one that offset the exposure. Such a swap provides the funded investor with a superior net credit spread to CDS on the same reference asset.
For e.g., an investor purchases FRN on which it earns a spread of LIBOR+60 bps. The position is then funded at say LIBOR+25 bps. Investor net credit spread is, therefore, 35 bps (60- 25). If the same risk is taken through CDS for a net spread of 30 bps, an asset swap is more favorable.
Key Risks Faced by an Investor in Asset Swap
Here are the risks which are faced by an investor.
#1 – Default Risk
Such investor is looking to earn an appropriate spread for the risk of bond issuer default. Investor normally compares the spread available from this swap to those available from equivalent risk FRN or Credit default swap.
#2 – Liquidity Risk
The asset swap investor buys an illiquidIlliquidIlliquid refers to an asset that cannot be converted to cash. Such assets suffer a valuation loss when sold in exchange for cash. Bonds, stocks and properties are some examples of illiquid investment. package investment. There is no quoted market price of such a swap. The only realistic way to liquidate it is by terminating the swap at a mark to market value and selling the bond. However, there is no guarantee that the terms of such unwind will yield desirable results.
#3 – Counterparty Default Risk
This risk is negligible for investment-grade asset swap and is real for high yield transactions. The default of the bond could leave the swap investor to unwind the transaction on terms that cannot be predicted in advance.
#4 – Credit Spread Risk
It is the risks that market credit spreadCredit SpreadCredit Spread is the yield gap between similar bonds but with different credit quality. If a 5-year Treasury bond yields 5% and a 5-year Corporate Bond yields 6.5 percent, the gap over Treasury is 150 basis points (1.5 percent ). may tighten or widen in response to changing the market view on the default of the issuer or rating change on the instruments.
#5 – Mark to Market Risk
Margin requirement brings another set of risks to asset swap investors. Change in OIS and LIBOR curveLIBOR CurveLIBOR curve represents graphically, the values of the LIBOR rate at various maturity intervals such as one-month rate, two-month rate, etc. and it is used by various banks and other financial institutions for determining the interest rate for debt-based products and other financial products. result in margin movements that should approximately offset by changes in interest rate sensitivity of bonds. However, the change in the value of swaps is monetized (through margin payments), but any change in bond value is unrealized. This can leave the swap investor to negative mark to market on the swap, which is offset by an unrealized gainUnrealized GainUnrealized Gains or Losses refer to the increase or decrease respectively in the paper value of the company's different assets, even when these assets are not yet sold. Once the assets are sold, the company realizes the gains or losses resulting from such disposal. on bonds.
- These swaps offer borrowers the possibility of converting their exposure in domestic currency or foreign currency floating rate.
- Asset swap has become a more useful method by making relative value comparison. This allows the borrower and investor to compare the bonds on a relative basis and describe them as cheap or expensive.
- Notional of such transactions is now widely used for making comparisons, and its credit spreads have become an expression of target funding costs and investment returns.
- As an asset and liability swap has become central to international financeInternational FinanceInternational Finance is a section of Financial Economics that deals with the macroeconomic relationship & monetary transactions between 2 or more countries. It includes concepts like Exchange Rates, Interest Rates, FDI, & Balance of Payments etc. , it allows an investor to earn spread over and above domestic interbank money market indices.
Some of the disadvantages are as follows.
- It is more complex than simple securities such as bonds and notes. For such a swap to be created, there must be a reason to buy them in preference to simple FRNs.
- In many cases, an asset swap is an arbitrageArbitrageArbitrage in finance means simultaneous purchasing and selling a security in different markets or other exchanges to generate risk-free profit from the security's price difference. It involves exploiting market inefficiency to generate profits resulting in different prices to the point where no arbitrage opportunities are left. trade which involves taking exposure on fixed coupon bondsCoupon BondsCoupon bonds pay fixed interest at a predetermined frequency from the bond’s issue date to the bond’s maturity or transfer date. The holder of a coupon bond receives a periodic payment of the stipulated fixed interest rate. and creating almost equal synthetic FRN from them but if often result in investor taking huge risks by leveraging their exposure.
Asset Swap is the combination of bond purchase and fixed Interest rate swap. This swap is not a distinct product but a set of products defined by the motivation behind the transaction.
This has been a guide to what is an asset swap. Here we discuss the example and motivation of asset swap with key risk faced by investors along with advantages and disadvantages. You can learn more about financing from the following articles –