Three years ago, five-year dollar bonds issued by Ford traded at 150 basis points (bp) over US treasury bonds, and holders were lucky if they found three banks willing to bid. Today, the spread has tightened to 50bp and investors have a choice of 50 or 60 dealers. Ford is not an isolated example. The credit markets have experienced a general "compression of spreads" during the past two years, according to Philip Forrester, director of global asset swaps at West Merchant Bank. Why?
The answer is rather complicated. Investors face a debt squeeze that is being partly answered by the asset swap market. Borrowers keen to lock in low rates, issue fixed-rate bonds. These are bought by financial institutions - as traders or end-investors - which swap the cashflows into floating-rate payments linked to Libor. They are left with a synthetic Libor-based asset to match their floating-rate liabilities. The consequent increased demand for fixed-rate bonds to swap into floating has compressed spreads in the Euromarket.
The root cause is that the banking system is suffering from excess liquidity. Chris Ellerton, banking analyst at SBC Warburg, says: "Loan quality is improving, non-performing loans have been written off and pressure on fees and commissions means a greater reliance on interest-earning assets."