Why Swap and Government Bond Yields Differ and May Not Predict Future Rates

# Swap/Bond basis: Bond rates "too high" or swap rates "too low"?


# Swap/Bond basis: Bond rates "too high" or swap rates "too low"?












I suppose this question is more of a discussion piece than a question per se, so I apologize in advance.

I've long been fascinated by the large negative basis between government bonds and swaps. These rates shouldn't be different as they are intrinsically linked and there is in theory a way to earn an arbitrage between them. At least in the text-book world, but oh well, frictions and reality.

The question i however keep pondering over, is the following: Is the government bond rate, or the swap rate, more likely to be a better predictor of "true" forward short term rates?

Asked more contrived: Suppose your life depended on predicting what the prevailing 1Y interest rate will be in 20 years. Is the government bond or the swap curve most likely to be an unbiased predictor, or is the truth somewhere in between?

- I know swap curves are sometimes considered "purer", but there is compelling evidence that swap rates have a negative bias. A BIS paper shows that negative swap spreads are correlated with the degree of underfunding in pension schemes. Put differently, when pension funds hedge long term liabilities, and simultaneously are strapped for cash, they develop a natural preference for the swap market due to the inherent leverage. In a more generalized fashion, there seems to be a trend in financial markets that products/derivatives with built in leverage tend to trade at a premium compared to the underlying cash market equivalents for presumably not too dissimilar reasons, which surely cannot be driven by market fundamentals.

- There is compelling reason to believe that long term government bonds have a "premium" built into the yield and hence a positive bias, due to persistently large issue volumes saturating the market as of late, and dealer banks balance sheet constraints imposed post 2008.

So are government bond rates "too high", or are swap rates "too low"? and can we even truly know this?

## Answer by NBF (score 1)

https://quant.stackexchange.com/a/79931

First - a lot of thing that seem the same are not and never were. Futures with convexity adj are not swaps even when you adjust for daycounts etc. Some traders will fit futures curves and swap curves and (they used to) trade the convexity. Swaps and Bonds are very different markets. First liquidity wise - Futures >> ONTRs >> Olds ~ Swaps. Swaps are a closed market between counterparties with ISDAs. Swaps are daily margined but may still have counterparty credit risk. You can't just get out of swap - you have to novate or assign it. It's a much smaller market as a consequence. Treasuries - you or I can buy them. No isda, no mra, no nothing. Sure, repo is harder. Also US Treasury repo is probably the best funding in the world, esp when they are on special, with very small haircuts (depending on the vol).

And, you're correct - swaps used to be LIBOR>>Treasury Funding (e.g., GC or special repo), when the Treasury spread was a proxy for public-private credit spreads. Nowadays, this component is gone in USD. (Side note, we used to think swap spreads could not go negative in the UK...this was clearly wrong).

Regardless, there is no abstract 'forward' rate as you originally brought up. It's nice to think about it and the books present it that way, but it never was true. We used to put 3m, 6m, 12m Cash LIBOR + 3M Futures + Swaps on the same curve. In retrospect, it was dumb. If you can't trade them the same you are making a great presumption by trying to treat them the same. Moreover, there is no risk-free rate--there are hundreds of short-rates and traders trade STIR and knowing the plumbing can be a source of income. I am not an expert in this area (I know a bunch of STIR traders and they know far more about the nuances).

One final thing - no forward rate is a good predictor. Bonds (and swaps) have a term premium in them. I believe it was Fama-Bliss who did the interest-rate premium paper in 1987. It fluctuates much more than expectations do. Oftentimes the best predictor of rates in the futures is rates today (i.e., RW hypothesis).