Swiss government bonds - still too expensive?
Around a year and a half ago, we reported on the high prices of Swiss government bonds. Now we are taking the pulse of the market again and shedding light on possible alternatives.
Around 90 basis points - that was the ten-year swap spread in August 2022. After two volatile years, it is now a good 50 basis points. This is still above the long-term average of between 0 and 40 basis points. The different maturities of the swap spread are currently diverging more than in the past. The short maturities are already back in the range of historical values. Even the surprising interest rate cut by the Swiss National Bank has so far not provoked any change.
What is the swap spread and what does it mean?
Swaps reflect the market's interest rate expectations and are a common instrument for many market participants to hedge interest rate risks. The swap spread is the difference resulting from the swap rate for a specific term minus the yield on a Swiss government bond with an identical term. In concrete terms: the Swiss 10-year swap, for example, is 1.16 per cent (22.03.24), while the yield on a ten-year Swiss government bond is 0.63 per cent (22.03.24). The swap spread is therefore 0.53 per cent.
The level of swap spreads is an indicator of the prevailing risk sentiment in the market. The following applies:
- If the demand for hedging interest rate risk increases, market participants are prepared to pay more for the hedge. Swapping the risk becomes more expensive and results in higher swap spreads.
- Furthermore, if demand for government bonds rises sharply, this leads to a higher swap spread due to the falling yield. Swiss government bonds are considered a "safe haven" in times of heightened uncertainty and high risk aversion.
- In the past, an increase in the swap spread could also be observed when the markets were pricing in interest rate hikes by central banks.
Uncertainties fuel risk aversion
The main drivers behind the divergence in yields on swaps and Swiss government bonds are primarily uncertainties such as the consequences of the demise of Credit Suisse, inflation or wars. In such a mixed situation, investors increasingly reach for the safe Swiss government bonds. This was evident at the most recent tender auction. The Swiss Confederation topped up two bonds maturing in 2033 and 2043 by a good CHF 400 million. However, bids totalling over one billion were submitted.
Flattening capital requirements of the Swiss Confederation
Another price-stabilising factor is the bond issue volume planned by the Federal Finance Administration for 2024. This is lower than before. Accordingly, bonds totalling a good CHF 5 billion will be issued for the current year. Taking maturities into account, the Confederation's bond portfolio will increase by CHF 1.8 billion. In comparison: in 2023 and 2022, the portfolio after maturities increased by CHF 3.4 billion and CHF 2.5 billion respectively. The main reason for the levelling off in bond volumes is the Swiss debt brake.
What is the Swiss debt brake?
The Swiss debt brake has been in force since 2003. It is a constitutional regulation that limits the maximum debt of the federal government. According to this regulation, expenditure must be in balance with revenue in the long term. For the state as a whole (Confederation with cantons and municipalities), the debt ratio measured according to the Maastricht method was around 27 per cent of GDP at the end of 2023. Switzerland's debt level is therefore very low by international standards. As a result, the Confederation tends to have to issue fewer bonds than countries with looser budgetary rules. The Swiss debt brake promotes financial stability and strengthens investor confidence in the country's long-term budget management.
Swiss government bonds still too expensive
If you look at the various sectors in the Swiss Bond Index, the relative attractiveness of Swiss bonds remains low, especially in the longer maturities. We remain underweighted in Swiss government bonds in our investment products. There are many alternatives with more attractive yields and similar risk.
Where are the alternatives?
Examples include cantons, Swiss cities, the Pfandbriefzentrale Schweizer Kantonalbanken or the Pfandbriefbank schweizerischer Hypothekarinstitute. Bonds from these issuers have AA to AAA ratings. They continue to trade at an attractive premium to Swiss government bonds and are considered very safe thanks to their high credit rating. The chart below shows the spreads relative to Swiss government bonds. The premium for Pfandbriefe in particular remains well above the long-term average. The annual yield on the Swiss government bond maturing in 2034 is a meagre 0.63%, whereas a bond from the Canton of Basel-Stadt, which is also AAA-rated, yields around 1.14%, and the Pfandbriefbank bond even yields 1.36%.
Where we remain cautious
Industrial sector: Even though the spread/risk premium has risen again somewhat recently, the spreads are in line with the average of recent years. In the case of cyclical companies, we expect spreads to rise as industry continues to weaken. The Purchasing Managers' Index (PMI) is regarded as an important early indicator of economic development. Even though the index recovered somewhat in February, it remained below the growth threshold for the fourteenth time in a row.
Due to the uncertain economic situation, the selection of issuers remains key, as higher refinancing costs can affect the financial stability of companies. We expect the credit spreads of solid, non-cyclical companies to remain stable.
What is a tender procedure?
The Swiss government bonds have been issued by tender since 1980. The issuance calendar for the coming year is published annually in December. As a rule, the auctions take place monthly on the second Wednesday of the month. Only the nominal interest rate and the term are fixed at the time of issue. The issue amount and the issue price are determined on the basis of the bids submitted. Participants in the auction process can submit as many "best" offers as they wish or at different prices. Allocation is based on the uniform price procedure (Dutch procedure). This means that the lowest accepted price applies to all. Consequently, only those who have offered at least the accepted price or "best" will be considered.
This article has been updated. Originally published on 11 August 2022.
