Decomposing Swap Spreads

Abstract

We analyze a six-factor model for Treasury bonds, corporate bonds, and swap rates and decompose swap spreads into three components: A convenience yield from holding Treasuries, a credit risk element from the underlying LIBOR rate, and a factor specific to the swap market. The convenience yield is by far the largest component of spreads, there is a discernible but not highly variable contribution from credit risk, and a swap-specific factor with higher variability which in periods is related to hedging activity in the MBS market. The model further sheds light on the relationship between AA hazard rates and the spread between LIBOR rates and GC repo rates and on the level of the riskless rate compared to swap and Treasury rates.

Keywords: Swap spreads, corporate bond spreads, term structure of interest rates

JEL Classification: E43, G12, G13