Asset Swap

An asset swap combines a fixed-rate credit risk bond with a fixed floating interest rate swap, transforming the bond into a synthetic floating rate note (FRN). The investor receives the relevant interbank benchmark plus a spread fixed at the initiation of the swap agreement and is often bought by credit-focused investors such as hedge funds, mutual funds, and large financial institutions.

The spread depends on

• Difference between bond market price and its par value.
• Difference between bond coupons and the market swap rate.

• An asset swap merges a fixed-rate bond with a fixed-floating interest rate swap, producing a synthetic floating rate note. Investors with a focus on credit acquire these, gaining the relevant interbank benchmark plus a predetermined spread.
• Asset swaps serve to assess bond values and manifest in two types: cross-currency swaps and liability swaps. These tools aid borrowers and investors in gauging whether a bond's price is favorable or excessive compared to others.
• Asset swaps are crafted through the amalgamation of bond purchases with fixed-interest rate swaps. This transaction, tailored to specific objectives, represents a bundled approach rather than an individual transaction.

There are two types, which are as follows.

#1 - Cross Currency Swap

It is a combination of bond purchases and currency swaps. It is a mixture of 3 components:

• Purchase of fixed-rate bonds
• Pay fixed IRS in the same currency as bond
• A currency basis swaps to pay foreign currency floating coupons and receive domestic currency floating coupons.

For e.g., investors may consider buying corporate bonds in a non-domestic currency and then transacting in currency swap to create a synthetic domestic currency FRN.

If the resulting spread is superior to the spreads available from the same issuer’s domestic currency bonds/ FRN, it will result in profit.

#2 - Liability Swap

Bond investors use similar but opposite transactions to exploit anomalies that will provide the cheapest source of finance in domestic and international bonds and financial markets, often described as liability swaps. They are structured by corporate borrowers seeking to obtain the cheapest finance in domestic or international markets.

Let's explain this by taking an example:

Blackrock fund borrows USD 10 million from a bank at a floating rate of LIBOR+30 bps. It expects the interest rate to rise in the future, increasing borrowing costs, and wishes to hedge its exposure. Therefore, it enters into an interest rate swap through a swap dealer wherein the fund receives a floating rate of LIBOR +50 bps and pays a fixed rate of 5% on a notional amount of 10 Million.

The net credit spread earned by the fund is 20bps (50 bps – 30 bps).

Some of the important motivations for investors.

#1 - Leverage

The cost of funding the investor bears is pivotal to asset swap transactions. Such investors typically look for leveraged exposures on a floating basis. The deal is usually compared to unfunded alternatives, such as the possibility of selling CDS protection on the same reference entity.

#2 - Credit Spread Opportunities

The main motivation behind exposure on a relative value basis is achieving the target credit spread. Investors normally do not hold simple accrual products till maturity and often attempt to liquidate them by entering into an opposite transaction with exact similar terms as the previous one that offset the exposure. Such a swap provides the funded investor with a superior net credit spread to CDS on the same reference asset.

E.g., an investor purchases FRN on which it earns a spread of LIBOR+60 bps. The position is then funded at, say, LIBOR+25 bps. Therefore, the investor net credit spread is 35 bps (60- 25). An asset swap is more favorable if the same risk is taken through CDS for a net spread of 30 bps.

Here are the risks that an investor faces.

#1 - Default Risk

Such an investor is looking to earn an appropriate spread for the risk of bond issuer default. Investors normally compare the spread available from this swap to those available from equivalent risk FRN or Credit default swap.

#2 - Liquidity Risk

The asset swap investor buys an illiquid package investment. There is no quoted market price for such a swap. The only realistic way to liquidate it is by terminating the swap at a mark to market value and selling the bond. However, there is no guarantee that the terms of such unwind will yield desirable results.

#3 - Counterparty Default Risk

This risk is negligible for investment-grade asset swaps and is real for high-yield transactions. The bond default could leave the swap investor to unwind the transaction on terms that cannot be predicted in advance.

#4 - Credit Spread Risk

The risk is that the market credit spread may tighten or widen in response to changing the market view on the issuer's default or rating change on the instruments.

#5 - Mark to Market Risk

Margin requirement brings another set of risks to asset swap investors. Changes in OIS and LIBOR curve result in margin movements that should be approximately offset by changes in interest rate sensitivity of bonds. However, the change in the value of swaps is monetized (through margin payments), but any change in bond value is unrealized. This can leave the swap investor with a negative mark to market on the swap, which is offset by an Margin requirement brings another set of risks to asset swap investors. Change in OIS and LIBOR curve result in margin movements that should approximately offset by changes in interest rate sensitivity of bonds. However, the change in the value of swaps is monetized (through margin payments), but any change in bond value is unrealized. This can leave the swap investor to negative mark to market on the swap, which is offset by an unrealized gain on bonds.

• These swaps offer borrowers the possibility of converting their exposure to domestic or foreign currency floating rates.
• Asset swap has become a more useful method for making relative value comparisons. This allows the borrower and investor to compare the bonds relatively and describe them as cheap or expensive.
• Notional of such transactions is now widely used for comparisons, and its credit spreads have become an expression of target funding costs and investment returns.
• An asset and liability swap has become central to international finance, allowing an investor to earn spread over and above domestic interbank money market indices.

Some of the disadvantages are as follows.

It is more complex than simple securities such as bonds and notes. For such a swap to be created, there must be a reason to buy them in preference to simple FRNs.·      

In many cases, an asset swap is an arbitrage trade involving exposure to fixed coupon bonds and creating almost equal synthetic FRN. Still, it often results in investors taking huge risks by leveraging their exposure.

Asset Swap is the combination of bond purchase and fixed Interest rate swap. This swap is not a specific product but a set of products defined by the motivation behind the transaction.

This has been a guide to what is an asset swap. Here we discuss the example and motivation of asset swaps with investors' key risks and advantages and disadvantages. You can learn more about financing from the following articles –

• Atomic Swaps
• Equity Swaps
• Debt/Equity Swap
• Swap Rate Definition