Unpacking Swap Spreads: Beyond Cash Yields in Bond Hedging

While macro-economic debates often revolve around cash bond yields, the practical reality for many institutional portfolios lies in the swap market. This distinction is crucial, as the cost and effectiveness of hedging strategies are often dictated by the nuances of interest rate swaps rather than merely by the performance of underlying Treasuries.

As of February 13, 2026, the USD 10Y swap rate stood at 3.9425%, ranging between 3.9215% and 4.0230% with a -1.17% weekly change. In contrast, the UST 10Y cash benchmark was at 4.056%. This seemingly small difference highlights a significant aspect of bond market plumbing: the swap spread. A negative 10Y swap spread, currently around -11.4 basis points (swap minus Treasury), can signal underlying market dynamics and implementation costs that traders cannot afford to ignore.

Why Swap Spreads Are Essential for Hedgers

For financial institutions and large investors, hedging exposure to interest rate risk through swap agreements is a common practice. This means the actual tradable reality and the effectiveness of a hedge are tied directly to the swap curve. Neglecting this can lead to unexpected losses, even if your directional interest rate view is correct. Several factors make swap spreads a critical indicator:

1. Revealing Hedging Demand and Supply Dynamics

Persistent pressure from market participants to receive fixed rates in the swap market can directly influence swap levels and spreads. This demand often stems from hedging activities related to corporate bond issuance, mortgage-backed securities, or other fixed-income portfolios. Conversely, dealer balance sheet constraints can create divergences between swap and cash market dynamics. Understanding these subtle shifts is key, as illustrated by the behavior of the Rates Volatility: The Hidden Stress Point Beyond the VIX, which can impact both instruments.

2. Uncovering Implementation Costs and Frictions

Even with a perfectly accurate macro-economic outlook, the profitability of a hedge can be eroded by market frictions within the swap market. These frictions include collateral requirements, funding assumptions, and technical factors unique to the swap universe. If you are using futures to hedge, closely monitoring the basis between futures and cash is essential. Similarly, for swaps, tracking collateral and funding dynamics is paramount. Being right on the direction of cash rates is not enough if your hedge is bleeding due to execution inefficiencies.

3. Dissecting Negative Swap Spreads

The current negative 10Y swap spread of approximately -11.4 bp is not a monolithic signal but rather a confluence of factors. It can indicate strong receiving pressure from hedgers, balance-sheet constraints impacting Treasury demand, or other technical factors within the swap market. This complexity underscores why assuming cash and swaps are interchangeable is a pitfall. Credit markets often serve as another crucial barometer, and understanding their dynamics alongside swap spreads provides a more holistic view.

The Dual Risks of Hedging with Swaps

When you employ swaps for hedging, your portfolio is exposed to two distinct types of risk:

1. Directional Rates Risk: The fundamental risk that overall interest rates move against your position (e.g., yields rising against a long bond position).
2. Spread Risk: The risk that the relationship between swap rates and cash Treasury yields changes unexpectedly. This ‘swap relative to cash’ movement can be a significant PnL driver, especially during periods of market stress.

For precision in risk management, it is imperative to track both legs of this equation. For example, if you own long-duration investment-grade credit and hedge by receiving swaps, you are effectively long credit spread and short swap spread sensitivity. Should swap spreads unexpectedly widen, your hedge could lose money even if cash yields fall, because the hedging instrument is behaving differently than the asset being hedged. Professional trading desks recognize this by decomposing risk into delta to cash yields, delta to swap rates, and delta to swap spreads.

Practical Guidance for Traders and Hedgers

• Do not assume interchangeability: Cash and swap markets, while related, are distinct and don't always move in lockstep.
• Track swap spreads as a separate risk: Especially for large portfolios, the swap spread should be managed as its own risk factor.
• Monitor funding conditions: Keep an eye on SOFR funding conditions and repo stress headlines, as these can indirectly impact swap dynamics.
• Beware of regime shifts: In times of market transition or stress, the 'plumbing' of the market – including swap spread behavior – can become the primary driver of profit and loss. This is especially true for those engaged in international bond markets, as seen in the discussion around Super-Long JGBs: Auction Passed, But Risk Remains for Global Rates.

Ultimately, a deep understanding of the swap market and its technicals is indispensable for effective risk management and successful hedging strategies in the bond market. Ignoring these intricacies means overlooking crucial P&L drivers and potential sources of unexpected risk.