Accurate, Focused Research on Law, Technology and Knowledge Discovery Since 2002

An Explanation of Negative Swap Spreads: Demand for Duration from Underfunded Pension Plans

Klingler, Sven and Sundaresan, Suresh M., An Explanation of Negative Swap Spreads: Demand for Duration from Underfunded Pension Plans (July 27, 2016). Available for download at SSRN: http://ssrn.com/abstract=2814975

“In September 2008, the US swap spread for 30-year swap contracts turned negative and is still negative as of today. Persistent negative swap spreads are puzzling, and the fact that they prevail only in 30-year swaps has not been explained. To this end, we offer a framework where underfunded pension plans’ demand for duration hedging leads them to demand fixed rates in interest rate swaps (IRS) with 30 years to maturity by funding them at floating rates. This demand when coupled with balance sheet constraints of swap dealers which arose after the crisis of 2008, can drive the long-term swap spread to become negative. We develop a simple model with stochastic term structure to derive these implications. We then construct an empirical measure of the aggregate funding status of Defined Benefits (DB) pension plans from the Federal Reserve flow of funds accounts. We show that this measure of the extent of aggregate under-funding is a significant explanatory variable of thirty-year swap spreads. We also show that this channel seems to be at work only for 30-year IRS and not for swaps with shorter maturities.”

Sorry, comments are closed for this post.