Bund volatility sparks uncertainty around futures delivery

Changing cheapest-to-deliver status catches some traders off guard despite Finanzagentur intervention

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A cloud of uncertainty surrounds the cheapest to deliver on the September German Bund future, as increased volatility in bond yields forces the market to repeatedly reassess which Bund will ultimately qualify when the contract expires.

“This hasn’t happened for many, many years – that there has been doubt on what is the cheapest to deliver in such liquid products as the Bund,” says the head of rates trading at a European bank.

European government bond yields have been on an upward trajectory since the beginning of the year, moving in tandem with interest rate rises and bouts of volatility following comments by the European Central Bank regarding rate moves to deal with rising inflation.

German Bund yields for the 10-year bond have risen from -0.11% on January 3 to a recent high of 1.77% on June 21 (see figure 1).

A number of Bunds could potentially be the cheapest to deliver upon expiry of the September contract, but big movements in yields mean traders have found it difficult to work out exactly which one will play that role when the time comes.

“It’s still not clear which bonds will ultimately be cheapest to deliver. It can switch depending on the volatility or the market,” says Leonard Nederhof, senior fixed income trader at Rabobank.

Bunds must meet certain criteria to be eligible for delivery for the futures contract. They must be a long-term debt instrument issued by the German debt agency, Finanzagentur, with a remaining term of 8.5 to 10.5 years and an original term of no longer than 11 years. They must also have a minimum issue amount of €5 billion ($5.1 billion).

In June, it was assumed that the 0% August 2031 Bund would be the cheapest to deliver into the September contract. But Finanzagentur was at the same time preparing to issue a 10-year Bund on July 6, maturing in 2032, that could also qualify.

As the coupon had yet to be fixed, and given the volatility in the market, there was uncertainty about whether this Bund would be the cheapest to deliver. As Bunds trade above futures, traders looking to capture the basis typically sell the Bund and buy the future. But as it appeared that the Bund they had sold might not be the one they received at expiry, traders looked to reverse the trade by buying the Bund and selling the future.

This activity was reflected in the net basis between the cheapest-to-deliver cash bond and the September future, minus the carry value of the bond – which is the difference between the bond yield and the financing costs. This difference was 0.155 on June 1 but had widened to 0.6 by June 16, according to Bloomberg data (see figure 2).

 

 

Finanzagentur was watching this part of the market closely, as uncertainty in the futures market could be bad for the upcoming Bund auction.

“Clarity and transparency with regard to the cheapest bond to deliver is important, as functioning futures markets are a prerequisite for smooth secondary market trading and thus for successful auctions in the primary market,” says a Finanzagentur spokesperson.

 

 

To prevent uncertainty around the bond issuance, Finanzagentur did something it had never done before. On June 21 it pre-announced the coupon of the new bond, more than two weeks ahead of the issuance date.

The debt agency hoped a pre-announcement would give the market enough time to calculate what would be the cheapest to deliver well ahead of the issuance of the new Bund.

“Due to the recently rising yields, there was a not-irrelevant probability that this bond could be cheapest to deliver in the September Bund. Therefore, it was important for market participants to have the relevant details to calculate the fair value of the Bund. The coupon was set ahead of time and announced together with our quarterly update on June 21 in order to create transparency as early as possible and to reduce uncertainties,” says the Finanzagentur spokesperson.

Whereas normally the bond’s coupon would sit at around par value at the time of issuance, which on July 6 would have been 1.21%, Finanzagentur had already set the new bond’s coupon at 1.7% to reflect the 10-year German Bund yield of 1.77% on June 21.

But despite the higher coupon, the combination of the new Bund’s longer duration and a Bund selloff across the curve meant that longer-maturity bonds were quickly getting cheaper. Rabobank’s Nederhof says the high coupon added “to the difficulty in determining what is the cheapest to deliver and has given the market a lot of insecurity about [what is cheapest to deliver] in the process”.

On July 8, the cheapest to deliver officially flipped to the new 1.7% Bund, according to Bloomberg.

Nederhof says some hedge funds tried to take advantage of this and put on basis-widener trades on the assumption there would be a wholesale closing out of the 0% Bund basis trades into the 1.7% Bund trade. But they were caught out when the Bund price moved higher again on July 12 and suddenly the 0% Bund was back to being cheapest to deliver.

The uncertainty is said to have also caused problems for real money investors who use the futures as interest rate hedges, because changes in the cheapest to deliver alters the risk profile of the futures contact.

“Whereas before you could just put on [a futures trade] and then you would know for sure that the delta is hedged, with changes in cheapest to deliver you have to revisit your hedging,” says Nederhof.

While the cheapest to deliver has remained on the 0% Bund since, Nederhof says it’s still possible that changes in the yield curve could flip it back to the 1.7% Bund, so the uncertainty persists. The net basis of the German Bund future and the cheapest-to-deliver Bund remained elevated at 0.2 as of July 18.

[The cheapest to deliver in the German Bund] can still switch depending on the market and there’s still a bit of insecurity related to the high net basis,” says Nederhof.

While Bunds are the biggest bond market in Europe, a similar phenomenon could be seen with the cheapest to deliver and futures basis in French and Italian government bonds.

In France, the market tried to calculate whether the 10-year French bond that was due to be issued on July 7 would be cheapest to deliver. The net basis between the cheapest-to-deliver French bond and the September future sat at 0.038 on January 3. By June 16, the basis had risen to 0.25.

Comparable moves could be seen in Italy. There the net basis for the September future was -0.05 on January 3 but by June 28 had reached a peak of 0.59. This market saw a sudden switch in the cheapest-to-deliver bond lasting for most of June, before reverting back to the original bond later in the month.

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