## Falling yields prompt review of 6% conversion factor for delivery-eligible bonds

CME Group has contacted clients about changing the way it values US Treasury bonds that can be delivered to satisfy expiring futures contracts. The current methodology has been cited by some as contributing to the market disruption in March – a charge strongly disputed by the Chicago-based exchange.

CME’s rule book permits the delivery of a wide range of securities to satisfy a maturing contract. For instance, T-Bond Futures can deliver into any US Treasury with a maturity of between 15 and 25 years. CME uses a conversion factor to make bonds that are eligible for delivery economically equivalent, by adjusting the price to reflect a standard yield-to-maturity of 6%. In practical terms, this means that if a bond yields less than 6%, a short seller would have to deliver more of them to satisfy an expiring contract.

CME is seeking feedback on whether the implied coupon should be lowered in response to the recent decline in yields.

“We have been conducting outreach to our clients to get their feedback on the coupon rate as part of our regular review of all our Treasury futures contracts,” says Agha Mirza, global head of interest rate products at CME. “We would consider a change based on client feedback and risk management needs.”

The review is expected to be completed by year-end, and the results will be made public.

Critics of the current 6% conversion factor say it results in less liquid, off-the-run bonds being the cheapest to deliver (CTD) against expiring futures contracts.

“Because the coupon is so high, it forces the shortest-duration [off-the-run] bonds to be cheapest to deliver,” says Chas Mancuso, chief executive at Next Level Derivatives, and the former co-head of fixed income futures at Jefferies. “And that sector is typically the least liquid.”

Next Level Derivatives is developing alternatives to CME’s US Treasury futures contracts.

###### Because the coupon is so high, it forces the shortest-duration [off-the-run] bonds to be cheapest to deliver. And that sector is typically the least liquid

Chas Mancuso, Next Level Derivatives

Garth Friesen, chief executive at relative value hedge fund III Capital Management, confirms that basis traders that arbitrage price differences between bonds and futures will seek out the CTD hedge to maximise profits. “Given the dynamics of the way the futures are priced, that there is a hypothetical 6% coupon, it’s typically an off-the-run that is the CTD,” he says.

This is not an issue when markets are functioning normally. But in times of stress, the liquidity mismatch between futures and CTD securities can result in big mark-to-market losses and severe pain for anyone needing to exit positions.

“It’s like the tail wagging the dog. The volume in futures is so large relative to the deliverable basket of off-the-run bonds that there is a liquidity mismatch between the two in times of stress,” says Mancuso.

### Switch option

This was apparent in March, when the sharp uptick in volatility during the onset of the Covid-19 outbreak forced several hedge funds to unwind basis trades, by selling US Treasuries and closing out futures contracts. As the selling intensified, bid-ask spreads in off-the-run securities, which are typically a fraction of a basis point, shot up to as much as 3bp in the 30-year bond. Normal service was only resumed after the US Federal Reserve took extraordinary measures to restore confidence in the market.

Mancuso says the conversion factor makes it harder to hold basis trades to maturity, as the values of the bonds purchased and the futures sold will not be the same after the conversion is applied. For example, CME’s conversion factor for an off-the-run two-year bond yielding 50bp is 0.9018. That means $100 million of these securities will be equivalent to only 901 futures contracts, worth$90.1 million.

CME says this is “intuitive”, as the conversion factor “generally reflects the value of the cash position relative to that of the futures contract”.

But Mancuso says it also creates a tail risk: “A bond basis hedge will change from a factor-weighted ratio to a one-to-one notional ratio at expiration, which can lead to additional risks of market fluctuations in the final minutes of trading.”

Mirza says the criticism of the conversion factor is off the mark. He says the problems in the rates market in March had nothing to do with the design of CME’s contract – and everything to do with the economic shock of the Covid-19 pandemic.

“It was a combination of external shocks, economic uncertainty and volatility,” he says. “And when that happens, I think every student of the market knows, it doesn’t impact every market identically, and that illiquid markets may get impacted more.”

CME’s Mirza points out that 99% of US Treasury futures expiring in March had already moved to the June contracts at the end of February, meaning delivery was not an issue.

One hedge fund trader agrees the problems in March “had nothing to do” with the conversion factor. The majority of traders had already rolled to the June contracts before fears about the pandemic caused volatility to explode. “The premise is correct – there is a tail risk – but this had nothing to do with the drama in my opinion,” he tells Risk.net.

CME has changed the conversion factor before, in 1999, adjusting it from 8% to 6%. Mirza says discussions with clients in 2015 and 2017 found no support for changing the rate.

“We are in constant contact with our clients, and are always open to adjusting our product specs relative to their needs,” he says. “We have been regularly seeking client feedback about this coupon level since 2015.”

Mirza says one benefit of the 6% notional coupon is that it reduces the so-called switch option, where the CTD changes between different bonds leading up to delivery. A higher conversion rate results in a more linear relationship that asset managers prefer, he says.

Mirza cites the 326% growth in Treasury futures open interest from 2009 to 2019 as evidence of the market’s level of comfort with the design of the contract: “The CME Treasury futures basket design, which has helped to aggregate open interest, generates consistent deep liquidity, which in turn has benefited asset managers.”

Others point to the fact that so few US Treasury futures are held to maturity as a sign that something needs to change. According to CME, only around 2.6% of contracts traded in the last 27 years resulted in delivery.

“There is little incentive to take delivery of an off-the-run bond,” says John Coleman, a fixed income group director at RJ O’Brien. “Who wants a bunch of semi-liquid securities?”

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