An explanation of negative swap spreads: demand for duration from underfunded pension plans

BIS Working Papers  |  No 705  | 
16 February 2018


This paper examines the reasons for the persistent negative 30-year swap spread. Because of the credit risk implicit in Libor, swap rates should exceed the (theoretical) risk-free rate and rise when bank credit risk increases. Further, Treasuries (against which swap spreads are computed) are "safe haven" assets whose yields fall during a crisis, so that they trade at a liquidity premium. On this basis, the 30-year swap spread should have increased after the Lehman default. Yet, instead, it declined into negative territory. This we seek to explain.


In our model, underfunded pension plans' demand for duration hedging leads them to optimally receive the fixed rate in long-maturity swaps. They can balance their asset-liability duration by investing in long-term bonds or by receiving fixed interest via an interest rate swap with long maturity. We predict that, if pension funds are underfunded, they prefer to hedge their duration risk with swaps rather than buying Treasuries. The preference for swaps arises because these require only modest investment to cover margins, whereas buying a government bond requires outright investment. Such demand, coupled with dealer balance sheet constraints, results in negative swap spreads. To test our model, we also construct an empirical measure of the aggregate underfunded status of pension plans in Japan, the Netherlands and the United States.


Our evidence suggests that the swap spreads tend to be negative when pension plans are underfunded. Using our measure of the aggregate funding status of US defined benefit (DB) pension plans (both private and public), we test the relationship between the underfunded ratio (UFR) of DB plans and long-term swap spreads in a regression setting. Even after controlling for other common drivers of swap spreads, we find that the UFR is a significant variable in explaining 30-year swap spreads. We also show that swap spreads for shorter maturities are unaffected by changes in the UFR.



The 30-year U.S. swap spreads have been negative since September 2008. We offer a novel explanation for this persistent anomaly. Through an illustrative model, we show that underfunded pension plans optimally use swaps for duration hedging. Combined with dealer banks' balance sheet constraints, this demand can drive swap spreads to become negative. Empirically, we construct a measure of the aggregate funding status of Defined Benefit pension plans and show that this measure is a significant explanatory variable of 30-year swap spreads. We find a similar link between pension funds' underfunding and swap spreads for two other regions.

JEL classification: D40, G10, G12, G13, G15, G22, G23

Keywords: duration, swap spreads, balance sheetconstraints, funding status of pension plans, defined benefits, repo, LIBOR