By Kirsten Donovan
LONDON, April 14 (Reuters) - Euro zone interest rate swap spreads held near their lowest levels in nearly a year on Wednesday, squeezed by heavy bond issuance and concerns over the funding of a rescue package for debt-laden Greece.
The swap rate represents the cost of exchanging a fixed-rate stream of interest payments for a floating-rate one, and the rate usually includes a credit risk premium over the risk-free rate represented by German Bund yields.
The difference between the two rates has been squeezed
tighter this week, with the 10-year swap spread
The spread flirted with the zero level in May 2009 before widening again.
Similar moves have been seen in the 5-year spread which
narrowed to as little as 20 basis points this week, led by
5-year swap rates
"The announcement of the (Greek) funding plan has sounded the starting gun for borrowers to race back into the debt markets, raising funds and adding receiving pressure to the swaps as they do so," said ICAP strategist Chris Clark.
One of the biggest weeks of the year for euro zone government bond supply -- with around 30 billion euros scheduled -- and fears that European governments may have to increase borrowing requirements to fund loans to Greece have kept pressure on government bond yields, allowing the swap spread to tighten.
"The market has replaced concerns over a potentially imminent sovereign default scenario by concerns over the shared fiscal implications of any bailout and the worrying precedent that this might create," said Citigroup strategist Steven Mansall. Analysts said they saw room for further tightening to come.
"I don't think we'll have Germany trading above swaps in 10-year but expect it to go tighter still," said David Keeble, rate strategist at Credit Agricole CIB, adding that he saw the spread hitting "low single digits".
The U.S. 10-year swap spread
In July, banks must repay 442 billion euros of 1-year money to the European Central Bank, which is seen leading to a sharp fall in liquidity in the euro zone banking system, pushing up Eonia overnight rates relative to Euribor rates.
"The 10-year German swap spread will also be influenced by this move. Thus, it is too early to start trying to fight the recent narrowing between German yields and swap rates," Credit Agricole's Keeble said. But Citigroup said that while they saw scope for the spread to test the zero level later in the year, it believed further compression in the near-term looked increasingly unlikely.
"Our models point to a more progressive grind tighter in spreads ... with potentially countervailing factors on the horizon, such as a resurgence of risk aversion as underlying fiscal concerns and supply burdens begin to weigh more heavily in other peripheral markets with tighter liquidity conditions," Citigroup's Mansell said.