One of the key terms for Australian fixed income investors is the Bank Bill Swap Rate, more commonly referred to as BBSW. While BBSW has many uses, for fixed income investors its main relevance is as a benchmark upon which we evaluate bonds or other investments.
BBSW is simply the short-term swap rate. In Australia, BBSW is the term used for interest rate swaps of six months or less and anything longer dated than six months is simply referred to as a swap rate.
What is a swap rate?
A swap is a financial instrument where one set of cashflows are exchanged (”swapped”) for another. The most common is for fixed rates to be swapped for floating rates, or vice versa. This is often used to match cashflows so that the risk of either being mismatched is largely removed.
For example, if a company received fixed payments under a contract for use of an asset but had a floating rate loan that was used to finance that asset, it may want to swap the floating loan payments to a fixed rate to match the income that asset generates.
Therefore, it can be seen that there is a rate at which, for a certain period of time, a payer or receiver (usually a bank) is indifferent between receiving a fixed and a floating rate of return. This is the swap rate for that particular tenor.
Risk free or not and how is it calculated?
BBSW has been compiled by the ASX since 2017, and prior to that by AFMA.
It incorporates a banking sector risk premium over and above the risk-free rate (i.e. government bonds) to reflect the chances of a bank defaulting and being unable to fulfil its obligations on the swap.
Typically, this premium is low (around 15-30 basis points [bp]) representing the strong credit quality of the banking sector, although in periods of stress, such as the GFC, it can expand to much wider levels.
There is a strong correlation between changes in the cash rate and the impact on the BBSW, as demonstrated in the chart. It must be noted, however, that other factors, in addition to changes in the official cash rate, impact on the market rates charged by banks and other financial institutions.
Using a very simple example which ignores bank sector risk, if interest rates are currently 3.50% and are expected to rise by 50 bp (1 bp = 0.01%, so 50bp = 0.50%) in six months and then remain unchanged, the 1-year swap rate would (theoretically) be the average over the year i.e. 3.50% for six months plus 4.00% for six months = average 3.75%. The 1-year swap rate would be 3.75 per cent.
In this way the swap rates for longer tenors incorporate market expectations for interest rate changes.
Use in the market
The purpose of the BBSW is to provide independent and transparent reference rates for the pricing and revaluation of Australian dollar derivatives and securities.
The 90-day BBSW is often referred to as the reference rate for market interest rates and is used as a benchmark interest rate for floating rate bonds and other floating rate financial instruments such as hybrids.
Coupons are reset every quarter from the issue date of the bond, with the issue spread being added to the 90-day BBSW rate on the reset date, which calculates the total interest rate paid for the coming quarter.
However, for fixed rate bonds, issuance of new bonds is typically for tenors longer than 3 months, and therefore the swap rate becomes the most used benchmark.
Yields on fixed rate bonds are determined, usually via a dynamic bookbuild process, combining the spread demanded for the credit risk of the issuer for that particular tenor, added to the relevant swap rate.
Worked example – NAB 6.322% 03/08/2027c and NAB BBSW +2.80% 03/08/2027c
NAB issued a bond in August last year with two tranches, one fixed and one floating rate, with a first call in 5 years’ time.
The credit spread offered by NAB was 280bps, or 2.80%, and therefore the floating rate bond pays a coupon, reset every quarter, of the 90-day BBSW rate plus the spread of 2.80%.
At the time of pricing of the bond, the 5-year swap rate (priced to the first call date) was 3.522%. Therefore, adding the credit spread of 2.80% to the swap rate of 3.522% gets the fixed rate set for the bond of 6.322%.
This works because, as mentioned above, the swap rate for the 5-year tenor is the rate at which an investor (or an issuer) is theoretically indifferent to receiving (or paying) a fixed or floating coupon. Therefore, at the time of pricing, the two yields are judged to be equal whether fixed or floating.
Over time of course, with changes in actual and market interest rates, these returns are likely to diverge from each other. This is typically why having an allocation to both fixed and floating rates in a portfolio is a good idea.