A swap spread is the difference between the fixed interest rate and the yield of a Treasury security of the same maturity as the term of the swap. In other words, the swap spread is the spread that the fixed-rate payer agrees to pay above the Treasury yield with the same term to maturity. The swap rate is the sum of the yield of a Treasury with a comparable maturity plus the swap spread.

The spread of the three-month LIBOR rate over the three-month T-Bill rate is the TED spread. In a LIBOR swap, the floating payments are three-month risk-free rate plus the TED spread. Even without credit risk, the fixed rate of a LIBOR swap (i.e. the swap rate) has to incorporate a fixed spread over the corresponding riskless Treasury rate in order to compensate for the floating TED spread. There is a high correlation between swap spreads and credit spreads in various segments of the bond market. Actually, the swap spread reflects the current amount of perceived risk in the corporate bond market.

Accordingly, the spread of the swap rate over the Treasury rate for a given maturity could be positive or negative. Empirically, both Treasury yields and swap spreads do respond to market realities and developments. More typically, each of these variables drifts in one direction. But, unlike the yields on the Treasury notes which advance a bit and then move down a bit, while drifting in one direction, spreads tend to move steadily, though slowly, in one direction. In general, the swap spreads tend to move in the opposite direction of the treasury yields. If the yields are increasing, the spreads will be expected to fall. However, although this inverse relationship holds most of the time, it doesn’t always do so. For example, this relationship during the second half of 2005 was characterized by a harmonized move: higher Treasury yields corresponded with higher swaps spreads. In short, “if treasury yields slump, swap spreads jump”.