What is a callable asset swap?
A callable asset swap is a special type of financial product. It is made up of two main parts:
- A callable swap
- A bond
The callable swap part lets the seller buy back the bond later if they want to. They can buy it back for a set price. This set price is called the strike credit spread.
How does it work?
Let’s say you are the investor who buys a callable asset swap from a seller. You now own the bond and the swap.
The price of the bond can change over time. If the price goes up, the bond is said to “tighten”. This is because the difference (or “spread”) between the bond’s price and its face value gets smaller.
If the bond tightens enough, the seller might decide to “call” the bond back from you. This means they use their option in the callable swap to buy the bond back.
When the seller calls the bond, you have to sell it back to them. The price you sell it for is the strike credit spread price. This was decided when you first bought the callable asset swap.
You also get your original investment money back when the seller calls the bond.
Why would someone buy a callable asset swap?
Potential for higher return
Callable asset swaps usually pay the investor a better return than just buying a regular bond. This is like getting a reward for giving the seller the option to buy back the bond.
Customization
The strike credit spread and other details can be customized for each deal. This lets the investor and seller negotiate terms that work well for both of them.
Why would someone sell a callable asset swap?
Keep bond price gains
If the price of the bond goes up a lot, the seller can buy it back at the lower strike spread price. Then they could sell it again at the new higher market price and make money.
Flexibility
The seller is not forced to buy back the bond. They only have to if they want to. This gives them flexibility to adapt to changing market conditions.
Risks for the investor
Limited gain potential
Your profit is capped at the strike credit spread. Even if the bond price rises a lot more, you don’t get to benefit from that extra increase.
Forced sale
If the seller calls the bond, you have to sell it. This happens even if you wanted to keep holding the bond longer.
What happens in credit markets matters
The tightening or widening of the credit spread is a key factor. Credit spreads are driven by credit market conditions.
If spreads are tightening, that typically means credit market conditions are improving. Bonds are seen as less risky, so their prices rise. This increases the chance that the seller will call the bond back.
The opposite is true too. If credit conditions worsen and spreads widen, bond prices will fall. Then it’s much less likely the seller will call the bond. The strike spread price won’t be attractive to them anymore.
So investors in callable asset swaps have to pay close attention to credit market movements. These will have a big impact on the outcomes.
Other names for callable asset swaps
Remarketable asset swap is another name for a callable asset swap. You might hear either term used.
