Anthony Peters
SwissInvest strategist
MAYBE IT HAS something to do with the fact that I was trained in an American bond market environment. Maybe it is that I am (despite being of mixed blood from four European nations and more or less quadrilingual) fundamentally a europhobe. Maybe it is simply that it doesn’t make sense. But I simply cannot get my head around the very European concept of what we all know as the “mid-swap”.
In 30 years in the market, I have never bought a mid-swap, sold a mid-swap, hedged in one or done a portfolio switch against one. In fact, it’s a little bit like sex amongst teenagers – everybody talks about it but nobody has done it. Mid-swaps are a clever concept but in the world of real-money investing, concepts are fine and dandy but if they are not tangible, they are of little use.
The use of derivatives in cash bond markets has always been strange and something which those who learnt their trade in the US spread markets will always find difficult to get their head around. Americans price and trade their corporate bonds over benchmark government bonds, as do the British – and that’s it. They will use G-spreads and I-spreads and Z-spreads and all manner of other benchmarks to establish the relative value of a security – as one tutor reminded me, if you haven’t got enough relative values to show up, try spreading over three month T-bills – but never to accurately price it.
Although spreads are useful in comparing relative value, the measure of a security is its own yield to maturity and that, as we all (hopefully) know, means nothing in the case of any bond other than a zero coupon where duration equals maturity and where there is no reinvestment risk. A coupon bond is, in reality, nothing other than a strip of zero coupon bonds where every coupon is a zero bond in itself. But I have found over the years that that simple explanation has the yield-to-maturity fans up in arms. I have never understood the value of calculating a yield to maturity to three digits as it is a pretty nonsensical and a totally unachievable return. Unless each coupon can be reinvested for the residual life of the bond at exactly the same rate, the calculation is not more than an educated guess at best and uneducated guess at worst.
In 30 years in the market, I have never bought a mid-swap, sold a mid-swap, hedged in one or done a portfolio switch against one
OUR COUSINS IN New York, by using Treasuries to spread over (the offer if you’re buying the credit product and the bid if you’re selling it), are showing me a trade I can do. They can actually sell me the hedge or buy it off me, as the case may be, and duration weighted if required.
A swap – a proper one, not a theoretical mid-swap – is priced with a bid/ask spread which then also encompasses the bid/ask spread of the underlying government bond which is used to hedge the swap. So the swap has two bid/ask spreads in it, namely that of the underlying and then that of the derivative itself. In doing that, there is a basis risk which is never mentioned.
I first truly understood how little basis risk was considered when I found Eurodeutschmark bond traders hedging cash positions in Bund futures. One of them eventually tried to explain this odd phenomenon to me by telling me that hedging in a futures contract was better than hedging in cash because the bid/ask spread on LIFFE and later the DTB was tighter than it was in the cash Bund market. I responded by asking him what the bid/ask spread could be on a future for which nobody actually makes a two-way price and how he accounted for the double basis risk between the future and the Bund and the Bund and the credit bond? I was met with a blank stare.
At that point I began to appreciate that nobody had thought this through. And it was within the same culture of willy-nilly hedging that the idea of using the mid-swap was born.
Not to put too fine a point on it, the fact that the US dollar bond market, in itself significantly more professional in practically every division than its European counterpart, has steadfastly ignored mid-swap pricing is to me proof positive that it’s not regarded as either particularly useful or in fact overly sophisticated. Mid-swaps introduces that same issue of double basis risk.
ADDED TO THE thorny subject of new issues being priced against this thing called a mid-swap, we now have UBS launching a pretty significant bond tender in Swiss francs, euros and sterling in which the pricing is also being expressed in mid-swaps.
In the past, I have seen the most amazing distortions in swap curves which were brought about by shenanigans in the repo market and driven by vagaries in the cheapest to deliver into futures contracts. Spreads might look fine but yields can still be squeezed beyond belief.
Ask some old-timers what the French franc curve looked like when the high coupon OAT 10% 5/2000 was the cheapest to deliver into the MATIF notionnel in 1993 and the bond was subsequently trading over 10bp rich to its peers, which totally shredded the curve. Then ask what happened to that seven-year Kingdom of Sweden 7-1/4% 5/2000 which looked so cheap to swaps but was fearsomely rich in simple yield terms. First day sales were as good as non-existent.
The mid-swap has in its own way become something of the God particle of the European credit markets. But its wide use alone does not make it right and I will probably ride off into the sunset at the end of my career still vainly arguing against its presence.