Swap rates have fallen below European government bond yields for several weeks—a rare shift that is forcing institutional investors to reconsider their interest rate hedging strategies.
Lucas Bouwhuis, senior portfolio manager at Achmea Investment Management, highlights this trend in a recent LDI market update, advising institutional investors to exercise caution before swapping out swaps for bonds. The current low level of swap spreads could persist, and spreads may narrow even further.
In recent years, the spreads between swap rates and bond yields in Europe have been consistently positive. This made interest rate swaps attractive for hedging interest rate risks: investors would pay a variable rate while receiving a relatively high fixed rate.
However, that dynamic has changed. The difference between swap rates and bond yields—once peaking at around 100 basis points in the summer of 2022—has steadily declined and recently turned negative for ten-year maturities.
The new normal
This shift isn’t surprising, Bouwhuis explains. In his analysis, he suggests that this may represent a “new normal” for swap spreads. He cautions: «We therefore think it is too early to convert swap allocations into bond allocations. This trend may continue, making such a switch even more attractive” in the future.
What did surprise market participants, however, was the speed of this development. Bouwhuis attributes this rapid change to several converging factors, primarily political and monetary trends: increased government demand for capital and the ongoing reduction of central bank balance sheets.
Supply surge and the Bund’s decline
The supply of government bonds has surged—and this trend is set to continue. Bouwhuis elaborates in conversation with Investment Officer: “The supply of government bonds has grown enormously and will only increase further in the coming years, particularly for German government bonds—which serve as the benchmark for swap spreads. Between now and 2026, as many Bunds will be issued as in the past fifteen years.”
Compounding this, the European Central Bank is phasing out its bond-buying programmes, meaning nearly all new Bunds must be absorbed by private investors. This increased supply pushes bond prices down and yields up.
At the same time, Germany’s Bunds appear to be losing their traditional status as a safe haven. The European Union is gradually moving towards joint bond issuance, despite existing hurdles. Additionally, Germany’s slowing economy undermines its safe-haven reputation. Some European countries are now performing better economically, eroding Germany’s distinctive edge and weighing on Bund prices.
Historical development of swap spreads
Structural change in spreads
The expectation that swap spreads will remain structurally negative stems from these developments, as they are not incidental. Bouwhuis also points to the situation with British and American government bonds, which have been dealing with negative spreads for some time. Spreads around Treasuries and UK Gilts are currently approximately minus 50 basis points.
“These international spread levels are not a bad guideline as a starting point,” Bouwhuis believes. “In the long term, German spreads could also approach that level. Minus 20 basis points should be possible.”