Mini Chapter Four
Asset & Liability Swap
Asset Swaps – Is a term used to describe a ‘swapped’ return whereby an investor in a cash product desires to convert the return on it into the same currency or their home currency or another currency floating or fixed rate.
- Same currency asset swap – converting a fixed coupon bond into a floating rate bond can be seen as yield differential between the same currency bond and swap yield. If 3y KTB (Korea Treasury Bond) yields 4.5% and 3y IRS in KRW is at 4% then a swap whereby one pays 4% and receives KRW floating rate + 50bps will have a zero Present Value (PV) and the 50 bps is the same currency asset swap spread.
- Cross currency asset swap – facilitates the conversion of a fixed coupon on a bond in currency A to a floating or fixed coupon in currency B. So in a marketplace a foreign investor who is long a 3y KTB @ a fixed coupon of 5% would fully hedge the cash flows on the bond to convert the returns to a floating rate in another currency. They would pay the fixed coupon of the bond to the dealer and receive the equivalent let’s say USD SOFR + spread (in basis points) on it. Notice that the fixed KRW rate is akin to the fixed KRW cross currency rate as in a fixed/float cross currency swap vs USD SOFR and the spread over USD SOFR would be equivalent to the difference between this KRW fixed coupon and same tenor KRW CCS yield.
- Connecting the Dots
Referring to the section on cross currency repos we can see now that asset swap level for an asset should theoretically be the same as the cross currency repo price of the asset.
Liability Swaps – Similar to an asset swap this is a term used to describe the swapping of funding cost of a liability of the borrower into fixed or floating rate in a currency of their choice.
- Consider an onshore Korean Corporate’s fixed rate KRW liability which can be swapped into KRW floating rate by receiving fixed rate KRW IRS or in this case a fixed/float liability swap with a dealer. The corporate borrower would receive the coupon on his fixed rate loan and pay a KRW floating rate index + spread (in basis points) to the dealer.
- And a Korean Bank’s fixed rate USD liability can be swapped back into KRW floating rate +/- spread with an interbank dealer by a) receiving fixed USD coupon and paying USD floating rate + spread b) receiving USD floating rate + spread and paying KRW fixed rate, in other words paying the USDKRW Float/Fixed cross currency swap. If it were a USD fixed rate loan of a corporate it would likely be swapped back into a fixed rate KRW loan by using a fixed/fixed USDKRW cross currency swap.
- Asset and Liability swaps therefore suggest the degree of attractiveness for both an investors’ return and a borrowers’ funding cost across different currencies relative to their local currency return/cost of funding.
Table 2 – Japan bills/JGB yields swapped into USD, EUR, GBP, AUD
| 3m | 6m | 12m | 2y | |
|---|---|---|---|---|
| JPY Bill Yield | -0.2% | -0.1% | -0.1% | -0.1% |
| JPY Asset Swap spread (bps) | -16.2 | -14.5 | -15.9 | -13.7 |
| JGB into USD ASW spread (bps) | 36 | 35.7 | 46.6 | 54.1 |
| UST / Tbills ASW spread (bps) | -6 | -5.5 | -13.8 | 9.8 |
| JGB into EUR ASW spread (bps) | 0.3 | -2.6 | -0.6 | 9.5 |
| German Bills ASW spreads (bps) | -53.9 | -69 | -75.2 | -80 |
| JGB into AUD ASW spread (bps) | 17.4 | 22.4 | 39.2 | 53.5 |
| AUD Bills ASW spread (bps) | 0.3 | 0.1 | -16 | -34 |
| JGB into GBP ASW spread (bps) | 17 | 23.2 | 32 | 39.3 |
| GBP Bills ASW spreads (bps) | -17.6 | 1.5 | -40.5 | -65.2 |
Source: Pandemonium.
- JTDB yield can be converted to a floating rate JPY OIS + spread by paying 3m JPY OIS.
- This return in turn can be converted to a USD SOFR + spread expression by paying USDJPY 3 month cross currency basis.
- Combining a and b would amount to JPY floating leg being offset and the fixed 3m JTDB yield being converted to USD SOFR + spread.
- Similarly JPY bill yields can be converted to other currencies floating rates + spread and their relative attractiveness can be assessed by comparing it to local bill yields as expressed in the same benchmark floating rate + spread.
- In our example above – foreign investors from across regions considered above would find investing their money into Japan bills and swapping it back to their home currency more attractive than their local sovereign bills.
- For an asset swap trader the calculations above are the first step to identify investment opportunities. But the ability to monetise/capitalise on such an opportunity would also be a function of i) rating of the underlying asset (Japan sovereign as in the example is highly rated as A+ by S&P) ii) country limits (also a function of rating of the underlying asset) on Japan in this case.
In the emerging markets world, Korea and Taiwan are two current account surplus nations with ageing demographics, mature growth cycles and hence the need to generate returns on domestic savings via exposure to foreign currency assets; onshore asset managers/lifers have large dollarised investment books. Much like the cash flow dynamic above that swapped the return on a foreign currency asset to the investor’s home market floating index + spread, local EM investors also compare the returns on foreign bonds swapped into their home market floating index + spread with local sovereign/corporate bonds yields. But the direction of cross currency basis flips in this case i.e. a Korean asset manager would receive USDKRW cross currency basis to swap the returns on a USD corporate bond into 3m CD + spread.
Similarly for liability swaps consider an example of a Korean Corporate contemplating raising USD funding. A key difference here vs asset swapped returns would be to assess attractiveness of a foreign currency funding by converting it to local currency + spread (let’s say KRW 3m CD + spread) and comparing it with the local corporate issuance yields expressed as 3m CD + spread again. Decision making process for raising 3y USD (as an example) funding would involve:
- 3y USD Corporate bond yield which would be a function of both the underlying 3y UST yield and the credit spread.
- For simplicity this can be converted to a USD SOFR + spread by receiving 3y fixed rate USD SOFR swap.
- And this in turn can be converted to a 3m Korea CD + spread by paying a 3y USDKRW cross currency basis swap to arrive at the equivalent local benchmark floating rate + spread.
- Comparing this spread with the equivalent 3m Korea CD + spread funding cost of the onshore corporate issuance yield would be key for arriving at the funding decision.
- Other considerations for foreign currency fund raising would be issuance costs (syndication fee, legal costs, listing costs et al), timing of issuance, regulatory permissions, ability (both of the issuer and market depth/structure) to issue in a specific foreign currency market.
To summarise – The impact of cross currency basis on asset and liability swaps for asset managers and corporate borrowers of the same country is diametrically opposite. Cash flow description above makes it clear that a deeply negative basis swap would ‘reduce’ the asset swap spread and ‘add to’ the relative attractiveness of foreign currency funding vs local funding, and vice versa.
