Key takeaways:
- The unusual cheapness of U.S. Treasuries relative to interest rate swaps makes corporate bond spreads appear tighter when measured against Treasuries than when measured against swaps. This effect is real, but primarily one of measurement rather than valuation.
- Despite this mechanical effect, changes in Treasury-swap spreads show little relationship with changes in U.S. corporate credit spreads, suggesting Treasury-swap dynamics are not a major driver of credit spread behavior over time.
- Europe is different. A more swap-centric market structure and shared exposure to banking sector funding conditions create a stronger link between Treasury/Bund-swap spreads and corporate credit spreads.
The relative cheapness of Treasuries versus interest rate swaps mechanically affects how corporate bond spreads are measured, but it appears to have limited influence on how corporate bond spreads actually behave. This distinction matters: While negative swap spreads can make valuations appear richer, the evolution of credit spreads remains driven primarily by credit fundamentals, investor risk appetite, flows, and broader market technicals rather than relative value between Treasuries and swaps.
Quick background: Corporate bond spreads represent the extra yield investors demand to lend to a company instead of a safer benchmark. The key question is which benchmark to use. Traditionally, investors measure spreads relative to U.S. Treasuries by comparing a corporate bond’s yield with the yield on a Treasury of similar maturity. Treasuries are often treated as the closest approximation of a risk-free asset, but their yields can deviate from the theoretical, and ultimately unobservable, risk-free yield curve due to temporary supply and demand imbalances. For example, quantitative easing – large scale central bank bond purchases – can push Treasury yields below fair value by removing supply from private investors. Large fiscal expansions and rising Treasury issuance can have the opposite effect by increasing the amount of government debt that private investors must absorb.
An alternative is to measure spreads relative to the interest rate swap curve. Many market participants view swaps as a useful alternative benchmark because they are less directly affected by Treasury-specific supply and demand dynamics. That does not necessarily make swaps a closer approximation of the theoretical risk-free rate. Like Treasuries, swap rates can also be influenced by market-specific technical factors, including hedging flows and shifts in demand from pension funds, insurers, mortgage investors, and other large market participants.
In other words, just as Treasury yields can be affected by technical forces unrelated to credit risk, swap rates can be influenced by dynamics in derivative and funding markets. The practical question is often less about which benchmark is “correct” and more about which set of market distortions investors wish to abstract from.
In practice, spreads to Treasuries are often better for communication, and most bond index spreads are reported on that basis. Spreads to swaps, however, can be useful for valuation work because they remove Treasury-specific distortions from the comparison. Today, the difference between the two is material. As shown in Figure 1, Treasury yields appear unusually cheap relative to swaps, with 10-year swap spreads remaining deeply negative by historical standards.
