The Bank of International Settlements (BIS) recently released data supporting the notion that swap end-users, including corporates, are continuing to access the swap market less to hedge risk, although indications point to that changing.
Culling BIS data, the International Swaps and Derivatives Association (ISDA) notes that daily average interest-rate derivative trading between reporting dealers and non-financial clients has remained fairly stable over the decade or so, ranging between 5.1 percent and 10.8 percent of total over-the-counter derivatives turnover. According to the BIS’ tri-annual survey, the rate dropped from near its high point in 1998 to its low point in 2001, and then proceeded to climb gradually to more than 10 percent by 2010.
Over the next three years, the rate began another steady decline that appears likely to have not yet reversed itself.
The turnover data reflects the gross value of new transactions entered into during the observation period. The volume of new transactions overall, including those between two dealers or a dealer and financial end user, changed little between 2010 and 2013, according to BIS data.
BIS’ June quarterly review shows the gross market values of interest-rate swaps, the bulk of swap activity and the variety most used by corporates, dropping each semester since December 2011, and from $15 trillion in June 2013 to $14 trillion in December. The gross market value includes swaps entered into sometimes years ago, and the BIS notes some reporting irregularities, so the data is less suitable than turnover numbers when comparing counterparty activity.
Nevertheless, the decline and more recent leveling off of activity, echoes current turnover dynamics. According to the BIS semi-annual survey, long-term bond yields and swap rates in major currencies rose in mid-2013 after announcements earlier in May that the Federal Reserve envisaged phasing out quantitative easing (QE). The decline in gross market value of interest rate derivatives over this period suggests that the bond market sell-off narrowed the gap between market interest rates on the reporting date and the rates prevailing at contract inception, providing little reason to hedge.
“If they’re hedging fixed-income products, interest rates going higher or lower changes the duration of your portfolio. So if rates aren’t changing much, then there’s less need to adjust your hedge by putting on additional swaps,” said Audrey Costabile, director of research at ISDA.
Mark Connor, principal of Corporate Treasury Investment Consulting, said that corporate treasuries typically seek to hedge floating-rate debt obligations, but it may be a period of time before that need returns. More recently, the trend has been to refinance with historically low fixed rates.
“If rates rise, corporate borrowers will have already locked in low, fixed-rate financing and will have little or no need for hedging,” Mr. Connor said.
That may be true for some but not all. Given near-zero rates for floating rate debt, many corporates have leaned toward retaining that debt as long as rates stay low, and some are voicing concerns that rates will rise, said Luke Zubrod, director of risk and regulatory advisory at Chatham Financial, which works closely with corporates on their hedging programs. He added that companies have generally been quieter in terms of hedging rate risk in recent months, perhaps because Libor rates have remained at record lows while medium-term fixed rates have increased.
“At the same time, we have had may discussions recently with corporates that are preparing to hedge their floating-rate risk, so it looks like the quiet of recent months will give way to a more active period of corporate hedging activity,” Mr. Zubrod said. He added this will be an evolving situation, and corporates may drag their feet implementing hedging strategies “in hopes that they can enjoy an extra quarter or two of low Libor rates before locking in higher long- or medium-term rates.”