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What is an Asset Swap?
An asset swap is a derivative contract between two parties that swaps fixed and floating assets. The transactions are done over-the-counter based on the amount and terms agreed upon by both sides of the transaction.
How an Asset Swap Works
Suppose a buyer wants to purchase a corporate bond but doesn’t want to take on fixed-rate interest rate risk. For example, they might be looking at a 10-year oil & gas corporate bond but prefer floating-rate exposure instead of fixed coupons.
To achieve this, the buyer can enter into an asset swap. They buy the bond in the market and then enter a swap where they pay the bond’s fixed coupons and receive floating payments linked to SOFR.
After this transaction, the investor holds a floating-rate position that is tied to the issuer’s credit risk. In other words, the swap has removed interest rate risk but left the credit risk intact. The compensation for taking on that credit risk is captured by the asset swap spread, which is the margin the investor earns over the floating rate.
Asset Swap Example
Let’s look at a specific example with actual numbers. We are looking at a risky bond with the following information:
Currency: USD
Issue: March 31, 2025
Maturity: March 31, 2030
Coupon: 7% (annual rate)
Price (Dirty): 105% of par value
Yield to Maturity (YTM): 5.75%
Swap Rate (compounded SOFR): 6.00%
Credit Rating: BBB
The investor buys the bond and enters into an interest rate swap.
First the buyer pays 105% of the par value for the bond, which has a 7% fixed coupon. The corresponding yield to maturity on this bond is 5.75%. The buyer then enters into a swap with a counterparty. In this swap, the buyer pays the 7% fixed coupons it receives from the bond to the counterparty and, in return, receives a floating rate based on compounded SOFR.
Next the asset swap spread is the difference between the bond’s yield to maturity and the corresponding swap rate. It is not calculated using the coupon rate or a price premium.
In practice, the asset swap spread is solved using discounted cash flows, but the yield-to-swap rate comparison provides a quick approximation.
The asset swap would be quoted at -0.25% versus the SOFR swap curve (or -25 basis points). A negative spread indicates that the investor is willing to take on the bond’s credit risk even though its yield is lower than the risk-free swap rate. This may occur if the investor is looking to create a floating-rate asset and the bond is the most efficient vehicle to do so.
The swap removes the bond’s fixed-rate interest rate risk, leaving the investor with exposure primarily to the issuer’s credit risk, reflected in the asset swap spread. Suppose the bond defaults in 2027, three years before maturity. Even though the bond stops paying its fixed coupons, the swap contract continues until maturity in 2030. The counterparty must continue to pay the buyer floating coupons based on compounded SOFR. This demonstrates how the structure helps the buyer transform a fixed-rate, risky stream of cash flows into a floating-rate stream where the credit risk is isolated.
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