Let us resume our tour of hedge fund strategies based on different types of fixed income arbitrage. An asset swap is an over-the-counter agreement between two counterparties to exchange fixed-rate interest payments for floating-rate interest payments.  The fixed portion is a position in a fixed-rate loan, such as government or corporate bonds.  The floating-rate portion is tied to a reference rate, such as the London Inter Bank Offered Rate (LIBOR) or the Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Rate.

Asset swaps are similar, but not identical to, interest rate swaps (IRS). IRS contracts are based on a notional principal – for instance, a $100 million interest rate swap doesn’t require the counterparties to spend that amount on debt; rather the counterparties are obligated to exchange interest payments as if they owned that much debt. In contrast, an asset swap involves the exchange of interest payments between a real bond position against a floating rate notional position.  An asset swaps allows a bond holder to change the cash flow characteristics of its bond position. The long side (the bond holder) of an asset swap pays fixed and receives floating from the short counterparty.  In a reverse asset swap, the roles are reversed.

Asset swaps can help hedge different risks, such as credit risk.  If I own a risky fixed-rate bond position and swap it out for a floating rate cash flow, I continue to receive that cash flow even if my bonds default.  The price of this insurance is that I receive a floating amount based on an interest rate that is discounted from LIBOR. The spot rate for swaps is called the swap rate, and the amount of the discount or premium represented by a swap rate relative to LIBOR is the spread.

Let’s take a concrete example, where the long counterparty has a position in Euro-denominated corporate bonds. We want to figure out the asset swap price (i.e. the spread) on this transaction.

The long counterparty pays 105.3% of par value to buy its bond position. The long would receive the fixed coupons of 5.5% of par value. The long counterparty then enters into an asset swap with the short counterparty, which happens to be the broker that sold the bond position to the long side. The long pays the fixed 5.5% coupon to the broker and receives a LIBOR-based (LIBOR +/- spread) floating rate cash flow.

To calculate the swap spread, two factors must be considered:

• The excess of the fixed coupons over the market swap rate is paid over the swap lifetime to the long counterparty. In this case, this excess is 5.5% – 5% = 0.5%.

• The present value of the difference between the (“dirty”, meaning with accrued interest) bond price and par value, spread over the swap lifetime. Since in this case the bond trades at a premium to par, the long side must pay this amount to the short counterparty. In this case, we will assume the amounts to a payment of approximately 0.23% for the term of the swap.

These two elements result in a net spread of 0.5% – 0.23% = 0.27%. Therefore the asset swap would be quoted as LIBOR + 0.27% (or LIBOR plus 27 basis points).

Hedge fund managers use asset swaps to tailor their risk exposures. An outright position (long or short) establishes which risks the manager is willing to accept. A boxed position, which is a mixture of long and short positions, allows a manager to hedge his/her risks.

In our next installment, we’ll examine the TED spread.