An interest rate swap is an agreement between two parties to swap cashflows (fixed vs floating) at set future points in time.
The party wanting fixed-rate obligations will be the fixed-rate payer and pay the agreed-upon swap rate at a semi-annual frequency throughout the contract term. The other counterparty, the floating rate payer, receives the fixed amount and pays a quarterly floating rate, which is set off the 3-month bank bill. This 3-month rate will change throughout the term, thus the floating side of the contract. The principal amount of the contract is ‘notional’ as it is never exchanged between the counterparties, just the cashflows exchanging interest payments.
Swap rates are a proxy for the risk-free rate. They represent the market’s expectations for interest rates over specific periods of time. Today, the five-year swap is trading at 4.85%, implying the market sees interest rates at an average of 4.85% over the next five years.
Swap rates also act as the link between Central Banks and the Market. Any policy changes by our Reserve Bank of New Zealand will flow through to swap rates and, therefore, those people engaging in swap contracts.
Financial institutions and corporates are both examples of parties involved in swap rate contracts, seeking to hedge interest rate risk by converting a fixed interest rate to floating or vice versa. Just as mortgage holders have the option to choose a fixed or floating mortgage rate, Institutional Borrowers can use swap contracts to fix or float their interest rate exposure.
Securities trading in the debt market are generally priced at a margin over the swap rate at the time of the primary offer and in secondary market trading. Demand is sought across a margin range for a new offer of fixed-rate securities, with the final rate sent at the margin plus the benchmark swap rate (of the same maturity as the fixed-rate security). The issue margin is the premium investors receive over and above the benchmark representing the specific issuer, and issue risk they take.
An example is Westpac’s offer of 5.5-year Tier 2 Notes, where the coupon rate was set at 6.73%. The coupon rate was calculated as the benchmark rate, in this case, the six-year swap rate of 4.73% plus the issue margin of 2.00%. The issue margin represents the credit risk of Westpac Tier 2 Notes over and above the benchmark.
Interest rate swaps are influenced by market forces such as supply and demand, domestic and international macroeconomic conditions, and expectations of future interest rates. The RBNZ’s policy moves and expectations of the OCR track largely impact short-term swap rates. In contrast, global movements have more influence on longer-term swap rates.
As swap rates reflect market expectations for interest rates, they will impact the interest rates on other products as well as debt securities.
Two obvious examples are term deposit rates and mortgage rates. As swap rates climb, mortgage and term deposit rates follow suit. Term Deposits have historically been higher than the underlying swap rate, reflecting the deposit-taking bank’s credit risk and is your margin for “lending” to the bank. However, recent volatility and clients looking to invest their money in term deposits safe haven have tested this rule of thumb. Of course, mortgage rates will be higher than term deposits and the underlying swap rate (if a fixed mortgage rate for a stipulated period) as this contributes to the net interest margin a bank earns as part of its business. This relationship between these three interest rates can be seen in the chart below.
Swap Rates are an essential component of the investing puzzle with a range of touch-points for both institutional and retail investors. The rates we receive on term deposits, fixed income securities, and the rates we pay on our mortgages will fluctuate with swap rates as the market adjusts its view on future interest rates.
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