An Explanation of Negative Swap Spreads: Demand for Duration from Underfunded Pension Plans
56 Pages Posted: 28 Jul 2016 Last revised: 5 Oct 2016
Date Written: October 4, 2016
The 30-year US swap spreads have been negative since September 2008. We offer an explanation for this persistent anomaly. Through a model, we show that the demand for swaps arising from duration hedging needs of underfunded pension plans, coupled with balance sheet constraints of swap dealers, can drive swap spreads to become negative. We construct an empirical measure of the aggregate funding status of Defined Benefits (DB) pension plans from the Federal Reserve's financial accounts of the United States and show that this measure is a significant explanatory variable of 30-year swap spreads, but not for swaps with shorter maturities.
Keywords: Pension funds, liability-driven investment, swap spreads, pension protection act, swap rates, limits of arbitrage
JEL Classification: G11, G12, G13, G22, G23
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