A smart trader seeks faultlines in financial markets: instances where prices for similar instruments have diverged. Such distortions are the bedrock of basis trades and arbitrage opportunities.
Examples in rates markets include a mismatch between government bond yields and the repo rate on the same instrument, or a gap between inflation forecasts inferred by bonds and derivatives.
These types of trades are traditionally the preserve of hedge funds, which can build multi-legged strategies spanning cash, derivatives and repo, to benefit from expected convergence. Structured products issuers typically haven’t been active in this corner of the market. Until now, that is.
Crédit Agricole Corporate & Investment Bank has cashed in on the upsurge of anomalies caused by rising interest rates and the end of quantitative easing, by parcelling up these basis trades into digestible structured note and repack formats. In doing so, the French bank opened up this non-directional exposure to a new type of investor.
“When the market is volatile and no one scenario is clear, it’s important to provide structured products that aren’t too directional, so the basis spread becomes a great alternative in this context because the market is volatile and clients want less directionality,” says Samy Ben Aoun, global head of non-linear rates trading at Crédit Agricole CIB.
Since late 2022, the bank has issued dozens of these trades, representing several billion euros of bond and derivatives notional. Their popularity helped fuel a doubling of Crédit Agricole’s structured notes business in 2023, with double-digit billions of euros issued, and more than 75 new distributors added to the platform globally.
It’s the culmination of a five-year project, which saw the bank rebuild its equity derivatives operations in 2019 in a bid to be more relevant in the equity structured notes space. With the rates cycle on the turn in 2022, Crédit Agricole CIB rejigged its structured sales team, bringing its fixed income expertise to the fore. Traders from across the linear, non-linear and repo businesses were also brought into the fold, alongside solutions and structuring teams.
“What we are showing now is that when we break the silos we bring value to our clients,” says Ben Aoun.
Pierre Scemla, global head of credit and non-linear, and deputy head of global markets trading, stresses the importance of trading expertise in converting complex ideas into an access note. “Our trading teams work up quite a sweat to get the deals done and bring value to clients. It’s not just an opportunity that’s easy to capture, beyond the structuring we really need to have everyone around for the execution.”
The bulked-up team got to work packaging a range of market anomalies across cash, derivatives and repo markets, into structured notes offering attractive yield pick-ups. Clients singled the bank out for its innovative approach.
“We want good ideas from the counterparty,” says one portfolio manager. “Two of those came from Crédit Agricole CIB, which are very innovative on structured notes.”
What we are showing now is that when we break the silos we bring value to our clients
Samy Ben Aoun
A London-based investment manager welcomed the diversification, adding that Crédit Agricole CIB offered “realistic alternatives” to existing exposures.
“The challenge is to present anything that is innovative to the right audience in a way that resonates. They’ve clearly done that better than others,” the manager says.
By repackaging known bases for broader appeal, the bank aimed to achieve triple goals of providing clients with non-correlated yield enhancement opportunities, opening up a new recycling avenue for the bank’s own axes, while also introducing new liquidity to help calm market stresses.
“It’s about crossing information coming from markets,” says Gael Riboulet, global head of fixed income solution sales. “We had opportunities coming from flow activities and were able to repackage this information in our investment approach for end-investors and institutional clients.”
An iota of difference
The inflation trade is a case in point.
Known as the iota spread, a discrepancy sometimes resides between inflation forecasts inferred from bond markets and those from derivatives markets. Asset swap levels on index-linked bonds versus asset swaps on nominals act as an indicator of the cheapness of index-linked bond break-evens compared to the inflation swap curve. The difference is commonly traded by hedge funds that can benefit from an eventual convergence.
In mid-2022, this gap grew, as commercial banks piled into inflation derivatives to hedge their asset-liability management exposure. The iota spread for 10-year French inflation-linked government bonds versus nominals hit more than 45 basis points in October 2022 – more than double the long-term average.
“Usually on this kind of basis you have a discrepancy between supply coming from the cash market and demand coming from the derivatives market. This was the case for French inflation,” says Ben Aoun.
Dealers on the other side of these inflation derivatives – including Crédit Agricole CIB – can theoretically hedge their own exposures by purchasing inflation-linked bonds. Yet regulatory constraints mean warehousing these instruments is capital intensive.
While hedge funds present an alternative risk-recycling opportunity for the exposures, their preferred investment horizon of under one year means dealers typically face a mismatch when looking to free up capacity to meet ongoing demand for inflation hedges.
Here the idea was to make the strategy much more simple, to allow investors who are not specialists in these markets to be able to position themselves on the iota basis
“The iota trade was already known, but people playing around that were mostly hedge funds through the short-term strategy. To monetise the iota, you need to have a credit support annex to trade inflation derivatives and be able to do a long/short on inflation versus nominal bonds. It’s quite a complex strategy,” says Nicolas Randazzo, Crédit Agricole CIB’s co-head of financial institutions structuring for Europe, the Middle East and Africa.
Crédit Agricole CIB saw a chance to offload this basis in synthetic format to an expanded array of investors, bundling the exposures into notes and repacks with multi-year maturities. The first notes, linked to French CPI, were sold in December 2022 and represented the bank’s own exposures from its linear inflation desk. The trade quickly expanded to other markets including Italy and the US.
“Here the idea was to make the strategy much more simple – as simple as purchasing a note – to allow investors who are not specialists in these markets to be able to position themselves on the iota basis,” says Randazzo.
Providing they can weather the mark-to-market volatility – French iota can swing between five and 50bp – noteholders are exposed only to the credit risk of the Crédit Agricole CIB notes, and achieve a guaranteed yield pick-up of 30bp-60bp providing they hold the instruments to maturity.
It’s not only Crédit Agricole CIB and its investors who stand to benefit. A 2014 study of inflation-related distortions in US Tips and Treasury markets suggests the relative cheapness of inflation-linked bonds costs sovereign issuers – and ultimately taxpayers – as much as $2 billion a year.
“This strategy improves the market efficiency for all players. If you have a market anomaly and you have a way to solve that anomaly, you will improve the market efficiency,” says Ben Aoun.
There’s some evidence it may be working – between late 2022 and March 2023 as the trade gathered pace, the 10-year iota spread on French government bonds more than halved.
Another market anomaly saw term repo rates on some high-quality liquid assets – primarily European government bonds – trade above the asset swap spread for the same security. This means the securities can be sold forward at a price that is above par.
Randazzo describes the phenomenon as “not natural at all”.
Economically, bond yields consist of three elements; the risk-free rate as represented by interest rate swap levels, the financing cost or repo, and the credit premium of the issuer – typically negligible for European government bonds.
“When you are in a situation where the repo is above the yield, that means implicitly that you are in front of a bond with a negative credit component, which doesn’t make any sense,” says Randazzo.
The anomaly largely stems from the derivatives market, which saw an upswing in demand for pay-fixed swaps from large pension funds and insurers to manage prepayment and asset-liability management risks associated with rate increases from mid-2022.
Sophisticated investors have been monetising this basis for the past couple of years through forward bond sales. The trade is equivalent to borrowing the bond via a reverse repo and selling it at par at maturity to profit from the difference. Catching this arbitrage requires investors to trade cash, derivatives and repo markets concurrently, putting the trade out of reach for many buy-side firms.
When you are in a situation where the repo is above the yield, that means implicitly that you are in front of a bond with a negative credit component, which doesn’t make any sense
By repackaging the basis into notes, Crédit Agricole CIB offers investors a yield pick-up ranging from 30bp to 70bp on one- to two-year instruments. At the same time, the bank was able to recycle long-term repo sensitivities on bond forward sales entered into with other clients, such as insurers and pension funds.
“The idea was to leverage this opportunity and make it accessible to a wider audience of clients – not only those able to sell forward bonds, which is basically a derivatives trade, but to clients who want to go into the note and those who don’t necessarily hold the bond,” says Randazzo.
The notes feature a range of highly rated securities including French, German and Belgian government bonds.
The same market anomaly drove another new development from the Crédit Agricole CIB team – the callable reverse repo.
During the low-rate environment, many banks enhanced yields on their liquidity portfolios, which comprise government and other highly rated bonds, with callable SSAs – or sovereign, supranational and agency bonds. Crédit Agricole CIB’s new note combines sovereign and other high-quality assets with an issuer call option, enabling buyers to lock in a yield pick-up stemming from the implied volatility embedded in the early termination possibility.
An alternative approach devised by Crédit Agricole CIB sees the same rates implied volatility exposure combined with attractive repo levels for an improved pick-up. Initial trades, which have been sold to banks since mid-2022, are structured as five- to seven-year reverse repos on European government bonds, under GMRA format, which are callable every year by the dealer.
The transaction offered the same 30bp to 70bp pick-up available on repo skew notes, while the dealer was able to neutralise some of the cross-gamma risk between repo and the yield curve, stemming from its sale of callable repacks.
To hedge their callable repack sales, dealers typically sell bonds and enter into a reverse repo at inception. When rates decrease, the bank’s reverse repo exposure increases, requiring it to sell more bonds, and vice versa when rates increase. The callable reverse repo provides the opposite exposure, meaning as rates fall, the bank increases reverse repo on the callable repack exposure, while reducing on the callable reverse repo.
So far, callable reverse repo has been exclusively a bank trade, but Crédit Agricole CIB believes the trade has broader application.
“[The] buy side might get involved, but banks are the most natural places because they’re used to using repo or reverse repo – it’s a daily thing for them,” says Randazzo. “Economically speaking, if you purchase a callable bond, you’re taking a credit risk with another bank. You’re taking a secured risk if you have the dealer in front of you. If you are covering the repo by an asset, it’s less risky. It makes complete sense for every kind of client.”
A much-discussed, but little traded, euro swaps anomaly also made its way into Crédit Agricole CIB’s expanding roster of basis trades – a persistent price gap between euro interest rate swaps cleared at London’s LCH and identical instruments cleared at Frankfurt’s Eurex.
This gap has been volatile amid a post-Brexit debate over how much euro clearing will be forced onshore, with 10-year swaps showing discrepancies as high as 4bp by March 2023.
The discrepancy reflects one-sided demand at Eurex, where EU-based clients tend to be fixed payers, particularly around the 10-year bucket. This leaves European clearing brokers, including Crédit Agricole CIB, as net fixed receivers at Eurex, with no natural offsets.
Monetising this anomaly in the derivatives market can be costly, as trading opposing positions across the two central counterparties incurs two sets of initial margin.
I like these trades because they have no correlation with the rest of the market
As a major user of Eurex Clearing for servicing its eurozone clients, Crédit Agricole CIB is directly exposed to this basis. The bank was able to package the mark-to-market of receive-fix exposure at Eurex and pay-fix at LCH into a note.
It’s a development the bank hopes will help alleviate the discrepancy: “If you’ve got a lot of [fixed] payers at Eurex it will increase the rate, but if you start to have some basis trades on Eurex-LCH, it will affect the basis and decrease the relative cost of Eurex versus LCH,” says Randazzo.
The trade is already familiar to many clients – Crédit Agricole CIB has offered similar instruments reflecting the basis between yen interest rate swaps at LCH and JSCC since 2017 – yet European accounts have welcomed the new version.
“I like these trades because they have no correlation with the rest of the market,” says one client. “These are so different and can work in any environment. It’s good to have diversification and with these trades it doesn’t depend on the duration, or stock market crashing.”
The Crédit Agricole CIB team knows only too well that true innovations have a short shelf-life. In 2018, the team’s groundbreaking constant maturity swap (CMS) 10-10 was copied by more than a dozen banks within three months. Similarly, rival banks were showing Eurex/LCH basis trades and repo skew trades in note format within weeks of Crédit Agricole CIB kick-starting these markets.
“We know we will be copied. Our future is to try something and keep innovating to see if we can bring some value to our clients,” says Ben Aoun. “You have a lot of risk premia in the market now and we’re exploring all of them.”
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