The Bank Bill Swap Rate, commonly known as BBSW, is the most
common measure of short-dated interest rates in Australia.
Strictly speaking, it is the rate at which Australia’s prime banks
borrow money for short periods, like three months or six
months. BBSW is normally near, but just above, the RBA cash
rate.
While BBSW has many uses, for fixed-income investors its main relevance is as the benchmark upon which other investments set their variable interest rates.
When banks agree to swap interest rate risk for longer periods, the floating side of that interest rate swap is the BBSW rate. These swap rates are often used as the benchmark for issuing new bonds.
Bank Bills
Bank bills are large-size, short-term, fixed-income investments. A bank will sell a
bank bill to raise money on a short-term basis. The most common term to issue is
six months, with three months also frequently used. Other terms do exist.
Bank bills are also tradeable in wholesale markets. A bank bill has a maturity date
and an issuing bank but can be traded between investors.
A bank bill rate represents the cost to a bank of borrowing money for a short
period. Notably, though, different banks will have different rates depending on
credit risk as well as general supply and demand effects.
The Bank Bill Swap Rate, better known as BBSW
Conceptually, the BBSW rates are short-term interest rates that represent the cost
to a generic bank of borrowing money for various short tenors. The tenors quoted
each day are one-month, two-month, three-month, four-month, five-month, and six-month BBSW. Because the rate is the average of the cost to banks, it is supposed to
be free from idiosyncratic effects on any one bank.
In Australia, the banks in question are known as Prime Banks. They are Australia’s largest and safest banks. At present, only Australia’s “big four” banks are treated as prime banks.
As of 1 January 2017, the Australian Financial Markets Association (AFMA) handed
over responsibility for calculating BBSW to the Australian Stock Exchange. The
process has been evolving and in May 2018 was confirmed in a paper ASX BBSW
Trade and Trade Reporting Guidelines. In a media release dated Monday 21 May
2018, ASIC outlined the new BBSW calculation methodology. Referred to as the
“BBSW Waterfall”, the new methodology is best thought of as a compromise
between different approaches to estimating the BBSW interest rates. The waterfall
is a list of different methodologies that will be attempted, in order, until a result is
found.
The best approach, actual traded prices, is the highest on the list. Less desirable
approaches, like a survey of major dealers, are further down the list. Each day,
BBSW is set by trying to use the highest level of the waterfall and, if that fails,
continuing down the list until a practical method is obtained for calculating the
BBSW rate on that particular day.
The RBA Deputy Governor at the time, Guy Debelle, said:
For more information, see FIIG's news article, 'BBSW changes complete', ASX- BBSW Conventions, or the ASX and ASIC websites. The most recent guide to BBSW is available here.
How Does BBSW behave?
Because BBSW is a short-term interest rate linked to the credit of very strong prime
banks, it usually sits near the RBA cash rate. However, because even the safest
commercial bank is not as safe as the Reserve Bank, the BBSW rates are generally
near, but a little higher than, the RBA cash rate.
One final wrinkle: because the BBSW rate covers a month or few months into the
future, whereas the cash rate only covers the next day, strictly speaking, the BBSW
rates tend to be near, but a little higher than, where the markets expect the RBA
cash rate to be on average over the relevant time period.
So, when the RBA is expected to cut rates imminently, the longer BBSW rates like 3M
and 6M can sometimes be a little lower than the cash rate. The converse is also
true. When the RBA is widely expected to raise rates imminently, BBSW rates will
reflect the likely higher interest rates over time and sit well above the cash rate.
BBSY
The BBSW process creates a set of interest rates that averages both bid and offer
prices. As such, the BBSW rate is the mid-rate.
‘Bid’ and ‘Ask’ values for each BBSW tenor are also published using a set difference
of five basis points above and below the BBSW rate.
The Bid and Ask values of BBSW are used, amongst other things, by market
participants to price floating rate loans. Being directly derived from BBSW and
where the only difference is the predetermined and non-variable bid / ask spread to
BBSW, these rates are a familial derivative of BBSW and are not considered a separate
benchmark.
The ten (10) basis point spread between the Bid and Ask values may not be changed
without the express consent of ASX, and consideration of any change to this spread
must be subject to prior consultation with the Committee and market participants.
BBSW on a 24-hour delayed basis is available here.
A quick digression: Swaps
So far, we’ve explained the relationship between bank bills and BBSW. But if the
BBSW is about Bank Bills, what is the S doing there? The “S” comes from Swap.
A Swap is a financial transaction where two parties agree to exchange risk profiles
with each other.
An interest rate swap is a financial instrument where one entity swaps a stream of
floating interest payments for another entity’s fixed interest payments. In practice,
they do not make two payments. Rather, a single net payment is made. This process
exchanges the fixed-rate risk profile for a floating rate risk profile and vice versa.
Although the fixed part of the interest rate swap is agreed when the swap is first
traded, the floating rate is supposed to change over time.
One of the key uses of BBSW is in the wholesale markets as the Bank Bill Swap
Reference rate – that is, the floating rate side of an interest rate swap.
In this way, a longer-term swap rate, like 3Y, 5Y, or 10Y, is built out of smaller chunks,
where each chunk is priced using the BBSW rate that applies on the future coupon
day.
Benchmarks
BBSW’s main use for bond investors is as a benchmark for floating interest rates.
The vast majority of Floating Rate Notes (FRNs), RMBS, and ABS use BBSW rates as
the benchmark. An investor who buys any of these notes will receive a coupon
based on BBSW, but with a coupon spread added to the BBSW rate.
But it’s not only floating rate notes that use BBSW as a benchmark. The other place
BBSW shows up in bond markets is when pricing a new fixed-rate bond. Because
BBSW is used to build swap rates, when a new fixed-rate bond is marketed as
“200bp area over swap”, it is in effect being marketed as “200bp over the
compounded return of the succession of future BBSW rates, as anticipated today”.