1. The interest rate swap market is, among other things, used to change the basis on which interest is paid on an asset or liability. Most commonly a floating rate is turned into fixed rate or vice versa. The fixed leg of the swap will be related to the Gilt market.
2. The swap market developed to allow borrowers who were not considered sufficiently creditworthy to access the fixed rate bond markets to lock into fixed rates of interest. As these borrowers usually borrowed from their banks (who understood their credit risk) swaps were and continue to be, generally intermediated by banks. As a result, the base swap rate (ie, the rate quoted before any corporate credit risk is taken into account) will itself reflect an interbank credit risk. This is generally considered to be an AA type risk.
3. The market convention is to quote a rate at which the bank will pay or receive a fixed or floating rate payment. This is the swap rate. The swap spread is the swap rate less the yield on the reference Gilt. Set out below is an example of a series of indicative swap rates as might be quoted on a broker's screen:
Maturity/Gilt | Swap Spreads (basis points) | Swap Rate (%) |
4YR 6H Tr 03 | +75/+70 | 6.87-6.8 |
5YR 6T Tr 04 | +87/+82 | 6.79-6.7 |
6YR 8H Tr 05 | +86/+81 | 6.71-6.6 |
7YR 7H 06 | +87/+82 | 6.62-6.5 |
8YR 7Q 07 | +90/+85 | 6.54-6.4 |
9YR 9 08 | +88/+83 | 6.46-6.4 |
10Y 5T 09 | +115/+110 | 6.39-6.3 |
12Y 8 13 | +119/+113 | 6.30-6.2 |
15Y 8 15 | +125/+117 | 6.15-6.0 |
20Y 8 21 | +126/+114 | 5.94-5.8 |
25Y 8 21 | +114/+102 | 5.82-5.7 |
30Y 6 28 | +125/+113 | 5.73-5.6 |
4. At its simplest, this would mean, for example, at 5 years, that if a borrower borrowing floating rate money at LIBOR + 1% wanted to pay fixed rate on the loan, the borrower would pay the bank approximately 6.79% and receive back LIBOR. It can be said, therefore, that the borrower's cost of borrowing is fixed at 7.79% for 5 years (6.79% + 1%).
5. As noted, the swap rate is the rate at which a bank will receive a fixed rate payment from an interbank counterparty and pay LIBOR (or vice versa). If the bank is transacting the swap with a corporate, the bank will add several basis points to the swap rate to take into account the credit risk of its counterparty. If the fixed leg is being paid by a AA bank and the floating by a AAA counterparty, the AAA counterparty would expect to pay a lower floating rate than the interbank rate.
6. The swap spread, therefore, is considered to reflect relative credit risk. Other things being equal, as the swap spread widens (ie risk is increasing and credit is becoming more expensive), floating rate borrowing for AAA borrowers becomes cheaper if they raise fixed rate bonds in the bond market and swap them in the AA banking sector. (In fact, generally, bond spreads will widen to make sure this arbitrage does not become too great).