Asset Swaps: Understanding Fixed‑ and Floating‑Rate Exchanges

What is an asset swap?

An asset swap is an over‑the‑counter (OTC) derivative contract in which two parties combine a bond (or other fixed‑rate asset) with an interest rate swap so that the economic exposure is converted from fixed to floating (or vice versa). These transactions are used mainly by institutions to hedge interest‑rate, currency, or credit risk; they are not typically available to retail investors.

How asset swaps work

• An investor buys a bond (often paying the dirty price, which includes accrued interest).
• Simultaneously the investor enters an interest rate swap with a counterparty (often the bond seller or a bank).
• Under the swap:
• The bondholder pays the swap counterparty fixed cash flows equal to the bond’s coupon payments.
• The counterparty pays the bondholder floating cash flows tied to a benchmark rate (e.g., SOFR) plus or minus an agreed spread.
• The swap’s maturity matches the bond’s maturity, so the floating payments continue for the life of the bond.
• In effect, the investor converts the bond’s fixed coupons into floating receipts (or vice versa), while remaining exposed to the bond’s credit unless additional credit protection is purchased.

Why use an asset swap?

• Hedge interest‑rate risk by converting fixed rate exposure to floating rate (or the reverse).
• Align asset cash flows with liability profiles (banks often convert long‑term fixed assets into floating to match short‑term floating liabilities).
• Obtain or sell protection against credit exposure as part of structuring the overall position.

Asset swap spreads

• The asset swap spread is the difference between a bond’s yield and the corresponding swap rate; it is usually quoted in basis points.
• Interpretation:
• A positive spread means the bondholder receives a premium over the swap rate for bearing the bond’s credit risk.
• A negative spread means the bondholder pays a premium to eliminate (or reduce) that credit exposure.
• Typical benchmark: many USD asset swaps reference the Secured Overnight Financing Rate (SOFR), which is based on transactions in the Treasury repo market.

Example

Suppose an investor buys a bond with:
– Fixed coupon = 6%
– Swap fixed rate = 5%
– Additional price/premium cost across the swap = 0.5%

Asset swap spread = 6% − 5% − 0.5% = 0.5%.

Under the swap the investor pays the bond coupon (6%) to the counterparty and receives floating payments of SOFR + 0.5% for the swap’s life.

How asset swaps differ from plain‑vanilla swaps

• Plain‑vanilla interest rate swaps exchange fixed and floating rate cash flows based on a notional principal, with no underlying bond.
• An asset swap specifically combines an actual asset (usually a bond) with a swap, so the underlying credit and cash flows of the bond remain part of the arrangement.

Credit risk and special structures

• Asset swaps can be used to manage credit risk: the swap buyer effectively obtains a form of protection because the swap counterparty pays floating cash flows even if the bond issuer defaults (depending on contract terms).
• Specialized structures exist (for example, asset‑swapped convertible option transactions, or ASCOTs) to separate and trade the fixed‑income and equity components of convertible instruments.

Key takeaways

• Asset swaps are OTC contracts that combine an asset (typically a bond) with an interest rate swap to change the economic exposure from fixed to floating or vice versa.
• They are tools for institutions to hedge interest‑rate, currency, or credit risk and to match asset cash flows to liabilities.
• The asset swap spread measures the compensation for credit risk relative to the swap market and is expressed in basis points; SOFR is commonly used as the floating benchmark in USD markets.