Return of the bear?

The collapse in bond prices since mid-June culminated early last month in the biggest blowout in swap spreads since the LTCM crisis. Though rumours of losses abounded, the fallout for dealers and investors may not be as serious as initially thought.

A bull run in US bonds that has lasted more than two decades may have ended on June 13. That was the day yields on US Treasuries began ratcheting back up off their 40-year lows. The sell-off in the US Treasury market in the weeks that followed caused mortgage investors to worry that the pace of mortgage refinancings would drop – extending the expected duration of their portfolios – and so triggered the one reaction bond investors feared most and understood least: mortgage investor selling.

The mortgage market has ballooned since the last big interest rate increase in 1994. It is now nearly $5 trillion – overtaking the $3.4 trillion Treasury market that mortgage investors tap to hedge it. So no-one knew how much the mortgage players would affect the fixed-income markets when they began to adjust their portfolios.

The answer was: a lot. The 10-year swap rate rose from around 3.4% in mid-June to 4.8% at the end of July, as market participants sold long swap positions (receiver fixed). Then, on July 30, the US Treasury announced details of a record $60 billion refunding package, sending the markets haywire – between July 30 and August 1 two-year Treasury yields surged by around 20 basis points (see figure 1).

The catalyst for the huge sell-off was convexity hedging by mortgage investors. The rise in rates since mid-June had dampened homeowner enthusiasm for refinancing their mortgages, and slower prepayment expectations caused a huge duration extension in the mortgage markets. According to Boris Loshak, interest rate analyst at Barclays Capital in New York, the mortgage index extended by around $600 billion in the 10-year swap equivalent during this period. “When you buy a mortgage you have to pray that rates stay stable. Or you have to convexity hedge and give up some yield to protect against a three-standard-deviation event,” says Loshak. Faced with an increased threat of rising rates and the extension risk it brought, mortgage investors sold Treasuries, putting the markets into free fall.

As mortgage investors dumped Treasuries and began to scramble for pay-fixed positions in the swaps market, swap spreads widened by 15bp between July 30 and August 1, a larger move than during the Long-Term Capital Management crisis in 1998.

No-one seems to have expected the extent of the sell-off or its violence. Barclays issued an interest rate advisory in late July stating: “[Swap] spreads should remain well behaved if economic data comes in as expected and rates become less volatile.” Similarly, UBS released a US interest rate strategy note on July 28, stating: “While Treasury/Libor spreads have widened in recent weeks, spreads should narrow in the coming months given the level of upcoming Treasury supply.”

Dealers’ trading books were exposed to the carnage. “Everyone had been riding long trades, whether in Treasuries, mortgages or swaps,” says Robert Lynch, vice-president in derivatives trading at the Royal Bank of Scotland (RBS) in New York. Few investors were particularly well hedged against the rate rise either. “There was too much complacency about carry on the rate move, and not enough hedging,” says Loshak.

Three-month by 10-year swaption volatility spiked by 11bp between July 30 and July 31 as investors belatedly scrambled to hedge their positions. Yet despite the unprecedented volatility levels, and rumours of losses, investors seem to have been able to limit the damage by re-entering the market after rates dropped in the second week of August.

Swap spreads came back in by around 14bp from their widest levels on August 1, reversing some of the damage for investors who had initially betted on swap spread tightening. “The value has come back into the market,” says RBS’s Lynch. “This has not been a train smash.”

And while large mortgage portfolios will have suffered, the damage does not seem to have been severe, as mortgage pass-through securities retraced much of the initial widening. “People should have got through it. Investors are better hedged, and there is not as much leverage in the market as in 2002,” says Eric Keiter, principal at $1.3 billion fixed-income arbitrage hedge fund MKP Capital in New York. “Mortgage funds have had a phenomenal run – so this kind of hurt is not too surprising, or catastrophic,” he adds.

Keiter says MKP will probably have given up 3% in July. He does not believe the volatility will cause another mortgage hedge fund blow-up like Beacon Hill, the fund which lost around $700 million at the end of 2002 on the back of huge leveraged plays in the mortgage markets.

Fannie Mae saw a large move in its duration gap (the difference in the duration of its assets and liabilities), from minus one in July to plus six in August, as a result of the sell-off. However, Linda Knight, Fannie Mae’s treasurer, says the company’s risk management techniques, which have included growing its option portfolio [callable debt and swaptions] from 54% of its overall portfolio at end-2001 to 75% at end-2002, held up well. “We have positioned the portfolio to withstand the most extraordinary periods in the financial market, such as we have seen recently,” she says. Also, Fannie Mae does not hold Treasuries as a hedge against duration risk, which allowed it to escape the sell-off in this market.

Wide bid-offer spreads
Meanwhile, banks that had large long Treasury positions may have lost money, but their swaps desks will have profited from the wide bid-offer spreads being charged at the time. There were also additional benefits for those playing basis trades in the credit markets (see box below).

The rush to hedge caused volumes in the swaps markets to spike in the first week of August, which led some market participants to complain of poor liquidity and difficulty executing trades. Exchange-traded contracts used to hedge against rate volatility saw huge volumes, and participants have complained about difficulty in accessing the market. The Chicago Mercantile Exchange’s (CME) Eurodollar futures contract – which is used by dealers and investors to lay off interest rate swap exposure – traded over 2 million contracts on July 31, the first time any CME contract has traded over 2 million in a single day.

But most liquidity problems occurred in large-volume trades. “In times of stress everyone is going to have to work hard – but things worked out pretty well,” says Peter Barker, director of interest rate products at the CME.

The turmoil also affected the swap broker market. “The broker market was frozen for a couple of days. We were seeing very wide bid/offers, reflecting the lack of liquidity in the market,” says Christophe Turpault, senior trader at Equalt, a fixed-income arbitrage hedge fund based in Paris, which trades US fixed-income securities.

Barclays, which last month launched an electronic trading platform aimed at its European client base, is said to have had to pull the platform temporarily when liquidity concerns proved too demanding (see page 8).

The US sell-off also had a contagious effect on the euro markets. According to Turpault, there has been a recent increase in the amount of arbitrage activity being carried out on the short sterling market. UK gilts witnessed a huge sell-off on the short end, with sterling swap rates rising from 3.63% to 3.94% between July 30 and August 1. But investors generally seem to have escaped any huge damage due to the gains made in the earlier part of the year.

David Harding, managing director of $250 million futures arbitrage fund Winton Capital in London, says the fund will have given up around 5% since the start of the June sell-off. But this merely reverses the 5% to 6% made in the earlier part of the year. Harding does say, though, that there could still be some large losses in the market. Whether this occurs remains to be seen.

Opportunity amid the chaos

The huge sell-off in interest rates, and the resultant widening in swap spreads, had a knock-on effect in credit markets, giving those quick enough to react a relatively risk-free arbitrage opportunity in early August.

Credit default swaps are priced off the Libor-based swaps curve, unlike cash bonds, which are priced off the Treasury curve. The jump in interest rate swap spreads on July 31 led to corporate spreads widening relative to Treasuries, while credit default swap spreads remained largely unchanged, as credit derivatives dealers adjusted their corporate spreads relative to the swaps curve.

“The credit default swap market adjusted its prices fully, since they all use swaps as their benchmark, while the cash market, [which is] more preoccupied with the Treasury benchmark, only adjusted somewhat,” says Mike Cloherty, market strategist at Credit Suisse First Boston (CSFB).

This created a basis widening, which was not initially captured by credit market participants. “Because of the huge volatility in rates and the thin credit markets, a lot of people in the credit sector took their eye of the ball,” says John Tierney, director in credit strategy and credit derivatives research at Deutsche Bank in New York.

The basis widening, which only lasted a few days, was, however, picked up by derivatives dealers and hedge funds active in that area. By selling protection (going long the market) and selling bonds (shorting the market), dealers, and aggressive leveraged accounts, were able to lock in the basis and position for convergence between the credit default swap and cash sectors. This created significant opportunities in certain names – Ford Motors’ basis widened by around 29 basis points to 46bp on July 31 while Citigroup widened by 10bp to 22bp.

The situation began to reverse itself after August 5. Interest rate swap spreads came in by around 10bp over the next week. The result was that corporates widened relative to swaps. So the credit default swap/cash basis moved tighter for a number of names, presenting opportunities to unwind previous basis trades or to buy bonds and protection.

Tierney suggests that the recent events could be indicative of a wholesale change in the way investors view the relationship between the corporate bond and swaps markets. “With the rise of the credit default swap market and its grounding in the swaps curve, there is an arbitrage mechanism to ensure that the corporate cash market remains better aligned with the swaps market.”

However, it is unclear whether any dealers or hedge funds would have been able to place the trade in any real volume over all the legs of the trade. “It is easier to spot the opportunity than execute the multi-part trade,” says CSFB’s Cloherty. “You can get into one leg and the other will move against you, because the markets have been so whippy.”