SEK Recommendation: Alternative Trades At Risk

Receive SEK 5Y5Y and pay SEK 1Y1Y in a risk neutral spread at 176bp. P/L: 155bp/190bp. Roll down: -4bp/m.

Money market curve has flattened whereas yield curves remain steep.

The recent performance of money market rates has led to a stretched situation compared with longer rates. Normally, the slope of the money market curve (FRAs) and the 2s10s bonds or swap curve spreads move together. Lower front yields and resilient long-dated yields have resulted in relatively high forward rates. We expect longer yields to start performing eventually. Forward rates have climbed and the Swedish long end has underperformed (Germany) despite the recent poor macro data and the soft Riksbank – see the 5Y5Y against 1Y1Y (see Chart 1) and spread to EUR swaps (see Chart 2) overleaf.

Moreover, the Debt Office is likely to need to step up its receiving in long-end swaps over the next couple of years (to offset issuance in bonds as maturities pick up in 2014 and 2015). This should be supportive for long-dated swaps. Later in the year, we expect Swedish L&Ps to adapt to the new construction of the discount curve (we do not think the sector has adapted yet, as the final decision on the discount curve will probably not be taken by the FSA before the middle of November). The new curve will be swap and Solvency 2 based and implementation will come into effect in 2014. We expect the spread between the forward swaps 5Y5Y and 1Y1Y, if anything, to benefit from this altered regulatory framework for L&Ps.

Possible to mitigate the negative roll
The forward spread has a nasty negative roll-down, -4bp/m, but it could be mitigated by receiving 9M 3M forward. Hence, receive 5Y5Y, pay 1Y1Y and receive 9M 3M forward. The negative roll is reduced by 50% to -2bp/m. This should also protect the trade if the market starts to discount a chance of rate cut late this year or early next year.

Alternative trades and risks
The box – 2s10s, in bonds or swaps versus 3rd/7th FRA contracts – is now close to record high levels (highs if we disregard the quick rate cuts by the Riksbank in 2009) and, thus, is a good alternative to the forward swaps trade 5Y5Y versus 1Y1Y. A very soft Riksbank later in the week could send money market rates even lower. However, in such a scenario, we would expect Swedish long rates to perform as well, as it should attract more foreign investors given the high yield spread to Germany/EUR swaps. Moreover, by receiving 9M 3M forward should protect the trade from such a scenario, as well as mitigating the negative roll (see above).

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