Europe bonds as futures derivatives mature

As European sovereign credits gain popularity with hedge funds, genuinely pan-European futures are adding colour to the trader's pallette, writes Euronext.liffe's Amanda Sudworth

The European government bond markets now clearly rank alongside the US government bond markets as an international safe haven for investment and a global source of liquidity.

It is not surprising that hedge funds are keen to be able to take positions in the marketplace as cheaply as possible to exploit any perceived opportunities, to benefit from anomalies in value.

Less price-sensitive investors, such as central banks and institutional investors, directly benefit from the liquidity that hedge funds bring to the market, through taking direct positions in the bonds themselves, and also indirect positions through the derivative markets. These include OTC swaps and options, the Bund, Bobl and Schatz German bond futures contracts traded on Eurex, and the two-, five- and 10-year Swapnote contracts traded on Euronext.liffe, as well as a variety of short-term interest rate futures and options products such as the heavily traded 3-month Euribor contracts on Euronext.liffe.

pan-european myth?

However, despite the variety of exchange-traded instruments available, the only longer maturity products able to be described as 'pan-European' used to be the various Swapnote contracts. Surprisingly, until this year, there was no genuine pan-European government bond futures contract and the marketplace had, instead, relied on the Bund futures traded on Eurex as a proxy for the total Eurozone government bond market.

This situation has now changed with the launch on 24 January this year of a new set of pan-European futures contracts by Euronext.liffe. The initial suite consists of a diversified pan-European futures contract as well as individual contracts for Germany, France and Italy, all based on the EuroMTS 7-10 year total return indices. If the concept proves successful, we will consider introducing further contracts at shorter and longer maturities.

In a recent report commissioned by Euronext.liffe and undertaken by StratCom, a research-based strategy consultancy, A Market Perspective on the EuroMTS Government Bond Index Futures, a number of key deficiencies in the current opportunity set for bond market derivatives were identified, which Euronext.liffe believes it can overcome through the launch of the new product suite.

In particular,

i)Bund futures are not representative of the market as a whole which, as last year's downgrading of Italy by Standard & Poor's and Fitch Ratings dramatically illustrates, is still a far from homogenous market, with different and very likely increasing credit divergences.

ii)Investment strategies involving taking positions on the relative credit strengths of individual members of the Eurozone will need a geographic spread of contracts if they are to be undertaken through derivative markets.

iii)A specific German bond, the cheapest to deliver in the basket of bonds available for delivery in the Bund futures contract, is used as a proxy to represent a much wider pan-European universe of bonds. This is not only complex and confusing for many market participants, but can also lead to market distortions through 'squeezes' in the supply of the deliverable bond.

Clearly, for both the futures contracts and the underlying bond indices, the accuracy of the pricing is critical, and a key requirement for the potential liquidity of the futures contracts is that there should be efficient arbitrage between the futures and the underlying portfolios of bonds in the indices.

This requires that the index prices are real-time tradeable prices. EuroMTS's indices are calculated using real-time bond prices from the over 200 firms on the inter-dealer MTS electronic trading system (a central, transparent platform for the trading of fixed-income securities) and in accordance with the rules and methodology, which MTSNext makes freely available.

There are more than 1,000 market participants across Europe, and with transaction volumes of up to €90bn each day (cash and repo transactions, single-counted), the MTS prices being used in the index calculations represent the best that could be obtained.

Institutional investors can also access the liquidity of the MTS platform through their business to customer platform, BondVision. As a result, the futures contracts should be able to be efficiently priced relative to their fair value with any small deviations being rapidly brought back into line through trading in the underlying bonds and the futures contracts simultaneously - arbitraging away the deviations.

cross-margining

The fact that the futures are trading on Euronext.liffe also raises the opportunity of conducting cross-margining with EURIBOR and other Euronext.liffe contracts, reducing financing pressures. This will undoubtedly be attractive to some participants.

Hedge funds will also find the futures useful to take short positions because the alternative is to borrow the bonds rather than the simpler route of selling the index directly.

StratCom's research among fund managers indicated that, not surprisingly, there is a great deal of demand for specific country contracts. French fund managers, for example, who are very familiar with the MTS indices (which were originally the French CNO indices) are generally enthusiastic about using the French futures for cashflow management as well as taking outright positions.

Yet interestingly, as one US fund manager commented, if one market was to be chosen as a replica of Europe, he would have chosen the French rather than the German as he felt that it is more advanced in terms of repos and more keenly priced.

Given the action by Standard & Poor's and Fitch Ratings last year, who downgraded Italy's sovereign debt, it is not surprising that there has been a strong demand for shorting the Italian futures contract. If the potential risk of the Eurozone disintegrating is seen to be increasing, it will lead to the convergence process seen during the 1990s operating in reverse.

Countries such as Italy, as well as Greece, Portugal and Finland would then be likely to experience large increases in yield differentials with a corresponding impact on bond prices due to the resurgence of their currency risk. Whether such fears will be enough to cause the Italian futures contract to always trade cheap or whether institutional fund managers will end up in an ongoing pas de deux with the hedge fund community, exploiting such anomalies, will be an interesting development to watch.

In contrast, while the German contract has some overlap in usage with the Bund futures, it is likely to be seen as an efficient tool for taking relative views against other Eurozone credits and does open up interesting opportunities for arbitrage with the Bund futures, as well as with the underlying basket of bonds in the index.

Longer term, the pan-European contract clearly has the potential to become the de facto standard futures contract for gaining exposure to the Eurozone marketplace as a whole by market participants of all types.

In the immediate future, it has great attractions for specific classes of investors, such as managers of retail Eurozone government bond funds, because it offers an easy and cost-effective mechanism for adjusting daily cashflows, as well as offering the opportunity to develop strategies for beating benchmarks by, for example, combining it with a portfolio of FRNs.

Are the new contracts likely to be seen as competitive to existing derivative and structured product contracts or complementary? The answer is probably both. Lyxor, for example, with €6bn already tracking MTS indices, recently launched an exchange-traded fund (ETF) based upon the 7-10 year EMTX Index (formerly the CNO Etrix Index) measuring the performance of the Eurozone's largest and most widely traded sovereign debt securities. Here, the EuroMTS Government Bond Index Futures will be ideally suited to managing the short-term cash flows in and out of the ETF. What StratCom's study has shown is that there is genuine interest by market participants around the globe in the EuroMTS Government Bond Index Futures.

As they point out, while liquidity will be a key determinant of usage, it will undoubtedly grow as market participants become more familiar with the product suite and the trading opportunities it presents.