What is the intermarket spread swap?
Key points to remember
- An intermarket spread swap is an exchange or sale of one bond for another with different terms, such as a different coupon rate, credit rating, or maturity date, to capitalize on yield spreads between bond sectors.
- By entering into an intermarket spread swap, the parties gain exposure to the underlying bonds, without having to hold the securities directly.
- Opportunities for intermarket spread swaps exist where there are differences in credit quality between bonds, which can allow an investor to diversify their exposure.
- An intermarket spread swap can occur when the rate of return on an investment on a bond changes, so that an investor “exchanges” it for a better-performing instrument.
Understanding the Intermarket Spread Swap
An intermarket spread swap can help produce a more favorable market yield gap for the investor. A yield spread is a difference between the yields of various debt securities with varying maturities, credit rating, and risk. In other words, a fixed income security is sold or exchanged for another security considered superior in some way.
By entering into an intermarket spread swap, the parties gain exposure to the underlying bonds, without having to hold the securities directly. An intermarket spread swap is also a strategy to attempt to improve an investor’s position through diversification.
Opportunities for intermarket spread swaps exist when there are differences in credit quality or characteristics between bonds. For example, investors would trade state titles for corporate securities if there is a wide credit spread between the two investments and the spread is expected to narrow. A party would pay the return on corporate bonds while the other will pay treasury rate plus the initial range. As the spread widens or narrows, parties will begin to gain or lose on the swap.
An intermarket spread swap can occur in a situation where the investment rate of return on a bond changes, so the investor “swaps” it for the better performing instrument. For example, if a type of bond has historically declined by 2% return ratebut the yield spread reveals a difference of 3%, the investor may consider “trading”, or essentially selling, the bond to try to reduce the difference and realize a higher profit.
Limitations of intermarket spread swaps
One of the important considerations of an intermarket spread swap is that the investor considers what determines the difference in the yield spread. Generally, bond yields tend to rise when their prices fall, but a savvy investor will also consider what causes those prices to fall.
For example, in a recession, a wide spread in yield might actually represent the perceived higher risk of that bond instead of just a bargain price. Buy what really boils down to junk bonds is a decision that should not be taken lightly by investors.