Swap spreads are a key market metric, but where should they be and will they remain steady? Or in other words, what drives swap spreads? Firstly, thinking about the fundamentals, swap spreads should reflect the expected difference between the reference rates on the swaps floating leg, such as IBOR or SOFR and the repo rates for the corresponding government bond. Let's have a look at why that is the case by walking through an example to help explain. Suppose an investor can buy a government bond locking in a yield to be received of 2.25%. That investor could also enter into an IBOR linked payer swap, paying a fixed rate of 2.39% and receiving a floating IBOR rate. To finance the bond purchase they could enter into a repo transaction paying the repo rates, which effectively allows us to borrow money to finance the purchase of the bond and posting the bond as collateral. The cash flows look like this. The investor receives the bond yield of 2.25%. They pay the fixed swap rate of 2.39%. They receive the floating IBOR rates, and they pay the financing cost at the repo rates. The net cash flow can be calculated as follows. We add 2.25%, then subtract 2.39% plus IBOR minus the repo rate. This simplifies to negative 0.14% plus IBOR minus repo rate. For this trade to break even the IBOR rate must on average be 14 basis points higher than the repo rates. Why might this difference exist? Well, IBOR rates reflect the cost of unsecured term funding, which incorporates credit risk.

In contrast, government bond repo rates are secured, they're backed by government bonds, and therefore have minimal credit risk. Due to this difference, you'd generally expect that IBOR swap spreads would be positive. As is the case here, the floating leg IBOR in credit risk, while the repo rates which influences bond yields does not. If the market expects the realized spread between IBOR and the repo rates over the next five years to be higher than this, due to an increase in credit risk on the unsecured funding perhaps, traders might buy the swap spread, which means buy the bond and pay fixed on the swap. This would drive up the swap spread and push bond yields down, widening the swap spread just as the market expected. Conversely, if the market expects the spread between IBOR and the repo rates to be lower, traders might sell the swap spread i.e. short the bond and receive fixed on the swap. Which would increase bond yields and lower the swap rates tightening the spread. It's a bit like a self-fulfilling prophecy, but what about SOFR swap spreads when the reference rate on the swap is a risk-free rate like SOFR? Theoretically, swap spreads should be zero or close to zero. This is because SOFR itself is based on the repo rate. In theory, there should be no difference between paying fixed on a SOFR based swap and funding through the repo market. In practice, however, we often see deviations from this theoretical relationship. The most important driver behind these deviations is supply and demand dynamics. While swap and bond markets are linked, they are also independent from each other and subject to different pressures. Swap spreads will naturally be influenced by imbalances between government bond trading, buying and selling, and swap trading, receiving or paying fixed. But why would imbalances happen? Let's take a practical scenario, a surge in corporate bond issuance. If companies were to issue more fixed rate debt, investors might hedge their interest rate exposure by entering into payer swaps. Pay fixed receive floating. However, this surge in demand for swaps might not be matched by an increase in government bonds trading. The higher demand for payer swaps drives up swap rates while government bond yields remain relatively unchanged. This would push positive swap spreads wider, or make negative swap spreads less negative.