# Hedge funds turn to curve options for steepener trades

## Previous bets on US interest rate curve flopped following unexpected flattening

Hedge funds are placing billion-dollar trades in curve interest rate options as they bet on whether the yield curve between the two-year rate and 10-year rate will steepen, according to three major banks.

The basis between both points on the US Treasury curve has tightened aggressively since the start of the year and now stands at 22.4 basis points. That contrasts starkly with data from a year ago, which shows the basis at 86.3bp.

“We’ve seen a lot of curve options trading now that the curve has flattened so much since the start of the year,” says a rates options trader at a large dealer in New York. “Some have traded it as they think the curve will steepen, while others see it as a cheap way of buying protection in case it does.”

Curve options work by paying out on the difference between two points on the curve versus a strike point. The most common are two-year versus 30-year and two-year versus 10-year. For example, a two-year versus 10-year call option with a 30bp strike pays the buyer 1bp times the notional for every basis point above the 30bp strike. Conversely, a put option pays the buyer 1bp times the notional for every basis point below the strike.

Bets on the curve steepening have been popular for at least the past 18 months, say traders, as the US Federal Reserve began raising rates at the end of 2015 and accelerated that monetary policy goal with a further six rate hikes. As a result, investors predicted these hikes would bring term premia back to the market, with yields on longer-term bonds further up the curve rising more than at the shorter end of the curve.

However, that scenario has not played out as predicted. Instead, the curve has become flatter this year, which traders say is largely the result of President Trump’s January tax cuts. These incentivise companies to top up corporate pensions before September, as these contributions reduce 2017 income subject to the older 35% tax rate.

A senior rates trader at a European bank says: “Because of the tax cut, corporations have until the middle of September to top up their pensions and get the full tax break for it, so there has been a rush to fund the pensions. As they have been flooded with cash, pension funds are then buying long-dated US Treasuries to hedge their liabilities which has been one of the dynamics that’s been pushing the back end of the curve flatter.”

The unexpected flattening of the curve resulted in losses. Participants say many investors originally involved in curve steepening trades have either closed out or moved into curve options instead. Originally, a number of funds were expressing the trade via interest rate swaps, US Treasuries or vanilla options. For those that do not have the mandate or capacity to make the bet using curve options, they have exited.

Curve options are appealing because rates volatility has remained low, meaning curve steepener options are considered cheap to buy. Investors have subsequently placed big trades. The senior rates trader says the standard size for this type of curve option has been around $2 billion in notional, equivalent to$200,000 in DV01 – the per basis point sensitivity to moves in interest rates.

Buyers are betting that the expected post-September reduction of pension fund flows will ease the downward pressure on the long end of the curve, pushing it steeper. They are also covering themselves from any fall at the short end if the Fed is forced to cut rates should the US economy hit a downturn. The idea is that a rate cut would reduce the shorter end of the curve, but leave the long end relatively unscathed.

###### We’ve seen a lot of curve options trading now that the curve has flattened so much since the start of the year
Rates options trader at a large dealer in New York

One variant on curve options that is proving popular is curve caps, which use constant maturity swaps to anticipate a widening in long-dated Treasury yields.

“We’ve seen tens of billions of notional in curve caps,” says Adam Shukovsky, head of US interest rate derivatives trading at Credit Suisse. “The fund investing is paying a small premium because the options are cheap. For example, you could pay as little as 1bp up front of notional. The risk/reward is pretty high as you can get paid out one hundred times what you are putting in.”

Other investors have been exploring different ways of benefitting from a steepening of the yield curve. Retail accounts are using structured notes such as non-inversion notes that pay out a fixed coupon as long as an underlying curve doesn’t fix below zero. Another popular trade has been reverse convertibles, where investors get their principal back at maturity if the curve isn’t below a pre-set level. If it drops below that level, then investors start losing principal.

“It’s rare to have retail to hedge funds to pension funds and large institutions all want to bet on the same thing – a steeper curve. It’s obvious why: the curve is super flat. But it’s rare that everyone lines up on the same side so often,” says the senior rates trader.

The rates options trader in New York agrees that the curve steepener trades are attractive to a wide range of parties: “Funds from the equities and credit space are going to be looking at it as a way to get protection against a broader portfolio.”

Observers note that a similarly one-sided trade occurred in the lead-up to the financial crisis in 2008. But Credit Suisse’s Shukovsky does not believe the move presages another market crisis. “It is correlation rather than causation, so I’m not worried about it but it’s still interesting,” he says.

Editing by Alex Krohn

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The week on Risk.net, September 8-14, 2018