Why a US fund manager added $4.8bn of Libor swaptions in Q1

Columbia Threadneedle’s eyebrow-raising trades were part of an effort to clean up legacy hedges

US-fund-adds-billions-of-Libor-swaptions

Call it subtraction by addition.

Columbia Threadneedle Investments added $4.8 billion of new US dollar Libor swaptions in the first quarter of 2022 despite a regulatory crackdown on fresh trades referencing the outgoing benchmark. The firm accounted for 42% of all new Libor swaption trades reported by US mutual funds in the first three months of the year, according to data from Risk.net’s Counterparty Radar service.

That may seem like a questionable move at first glance, but the trades were part of a “clean-up” operation aimed at offsetting existing Libor hedges before the benchmark is discontinued after June 2023. Columbia Threadneedle’s overall exposure to Libor swaptions fell by nearly $2 billion during the quarter as more than $6 billion of legacy trades came off the books.

The transactions illustrate the quandary facing asset managers. On the one hand, regulators want them to wind down their legacy Libor exposures. On the other, they are barred from entering new Libor trades, with limited exceptions. But with derivatives portfolios, the most efficient way to reduce exposure may be to put on new, offsetting trades – which invites further regulatory scrutiny.

“It certainly isn’t always possible to reduce your Libor-based swaption exposure and ensure best execution at the same time by terminating existing Libor-based swaptions,” says a buy-side derivatives trader in New York.

Columbia Threadneedle is navigating this fine line. While the firm stopped purchasing new cash instruments referencing Libor at the start of the year, it has continued to transact Libor swaptions to offset legacy hedges.

“Beginning January 1 of this year, we did not participate in any cash instruments based on US dollar Libor. On the derivative side, we’ve done risk-reducing trades to a modest extent,” says Gene Tannuzzo, global head of fixed income at Columbia Threadneedle. “If we were engaged in a one-year, 10-year Libor receiver swaption with six months left until expiry, we could do a six-month tenor trade to offset it. It looks like a different instrument, but it’s essentially offsetting the same risk.”

 

 

The new Libor swaptions trades were concentrated in funds investing in mortgage-backed securities (MBS), including Columbia Threadneedle’s Mortgage Opportunities Fund and Strategic Income Fund. Due to their negative convexity, the duration of mortgage assets is highly sensitive to changes in interest rates. Investors use swaptions to manage this risk. Receiver swaptions hedge against failing rates, while payer swaptions offer protection when rates rise. The hedges must be continually adjusted in response to changes in interest rates to maintain a portfolio’s target duration.

The ban on new Libor trades creates a headache for investors looking to take profits on legacy hedges as rates rise.

“You’re naturally exposed to interest rate volatility because the cash flows of that security change with the interest rate environment whether you’re hedging that with Libor or SOFR. You want something that’s going to be as close as possible to the yield curve associated with those bonds,” says Tannuzzo. “If you already have part of that hedge with Libor, rather than create a basis, I’d rather offset and reduce that position, particularly if it’s a position that's been beneficial. If we had a payer swaption that benefited from the fact that rates had risen over the last six months, we may simply want to just offset that and lock in those gains on that hedge.”

SOFR, the secured overnight financing rate, is the regulator’s preferred replacement for Libor.

Columbia Threadneedle’s new US dollar Libor swaptions were almost entirely written payers, totalling $4.5 billion notional. Nearly half of the new positions were allocated to two funds: $1.2 billion to the mortgage-heavy Strategic Income Fund and $1.4 billion to the Mortgage Opportunities Fund, which also added $630 million notional of written payers referencing SOFR.

Other mortgage funds stuck mostly to SOFR. Pimco’s Mortgage Opportunities and Bond Fund reported $1.7 billion in new written SOFR payers and $3.1 billion in new bought SOFR payers. Meanwhile, Putnam Investments’ Mortgage Securities Fund traded only SOFR swaptions in the first quarter and did not report any new US dollar Libor trades.

US banking regulators lack the authority to ban Libor trading outright but have urged market participants not to enter into new contracts, barring a few exceptions. An official statement issued in November 2020 calling for no new Libor contracts to be written from this year provides an exemption for “transactions that reduce or hedge the bank’s or any client of the bank’s US dollar Libor exposure on contracts entered into before January 1, 2022”.

The buy-side derivatives trader in New York says the new Libor trades executed by Columbia Threadneedle appear to be risk reducing and “in line with what I understand to be the spirit of ‘no new Libor’”.

Anne Beaumont, a partner at the law firm Friedman Kaplan, notes the onus is on banks to follow the regulatory guidance when trading with clients. “The limits on Libor usage are really more on the bank side,” she says. “As a practical matter, they flow through to the customers of the bank – if the bank can’t do it, the customers can’t do it.”

Citi was Columbia Threadneedle’s largest dealer for Libor swaptions trades in the first quarter, followed by Morgan Stanley, regulatory filings reviewed by Risk.net show.

 

 

While Columbia Threadneedle’s first-quarter Libor transactions are within the rules outlined by regulators, it is an outlier in the industry. Among all US mutual funds, SOFR swaptions represented 86% of new positions by notional in the first quarter, when the ‘no new Libor’ mandate kicked in, up from 2% in the final quarter of 2021.

Some fund managers switched their swaptions activity almost entirely to SOFR. Pimco, the largest user of swaptions among US mutual funds, conducted nearly all its new US dollar swaption trades by notional in SOFR during the first quarter.

At BlackRock and Putnam, over 90% of new swaptions notional referenced the replacement benchmark.

But the industry has been slower to transition legacy books. US mutual funds still hold $143 billion of swaptions tied to Libor, representing two-thirds of overall US dollar positions. While three-quarters of those positions will expire before July 2023, some managers have sizeable exposures that will live on long after Libor’s discontinuation. Putnam Investments’ $27.4 billion US dollar Libor swaptions book, for instance, has a volume-weighted average time to expiry of over 40 months, more than double the industry average.

 

 

By that measure, Columbia Threadneedle is in good shape – the volume-weighted average time to expiry of its swaptions book was just four months as of the first quarter.

Tannuzzo says Columbia Threadneedle was motivated to clean-up its swaptions book in the first quarter before Libor liquidity disappeared entirely. “The liquidity in Libor-based instruments was largely available in January, February, maybe March, which is why in many cases we wanted to put on offsetting trades. A lot of that activity was clean-up activity,” he says. “We would expect that by the end of this year, there’s just not going to be a lot of volume done.”

As of July, SOFR trades already account for over 90% of all swaptions activity, according to data from the Depository Trust & Clearing Corporation.

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