CBOT explores re-launch of corporate bond futures

The Chicago Board of Trade (CBOT) is exploring market interest in a new corporate bond index futures contract, and will decide whether to draft contract specifications within the next few weeks, according to Julie Winkler, a senior economist involved with product development at CBOT. If a decision is made to go ahead with the new contract, Winkler said the product could launch within the year.

Winkler said institutional investors are finding US Treasury bonds and US Treasury futures a less effective hedge for their investment grade credit exposure than in the past. “People are saying there's not the spreading and hedging opportunities there like they used to be,” said Winkler. An earlier corporate bond index future launched by CBOT in partnership with the publication Bond Buyer in 1989 failed, according to CBOT officials, because Treasury futures were then considered an adequate hedging market.

Winkler said that for many large investors, hedging corporate risk through the rapidly growing credit derivatives markets is not possible due to restrictive investment guidelines. She described insurance companies in particular as facing several hurdles to hedging with derivatives. “For every single new product they want to use they have to first get approval from their board and then go to their state commission. A lot of that takes a really long time to do,” said Winkler. “We've been finding a lot of them aren't using anything to hedge their corporate exposure, which is kind of scary when they may have a billion dollars or so in corporates that they're holding,” she added.

Winkler said the chief concern that fixed-income managers spoken to by the CBOT have about a new corporate bond index futures contract is the size of the index and its tracking error. “We've introduced some ideas to them about doing a kind of smaller sub-index of the Lehman or a smaller Dow corporate index,” said Winkler. “As soon as there’s any little bit of daily standard deviations in the tracking error it is of the utmost concern to them,” she said.

The CBOT began its market survey in early December with insurers, small pension funds, large mutual funds and fixed-income investment managers, said Winkler. Corporate bond dealers have long been interested in the development of corporate bond futures, which they could use to hedge their natural long position in the market. The challenge has been to find natural long interest to match the interest of dealers to short their exposure.

The Bond Market Association (BMA), which represents US dealers, has also investigated launching corporate bond futures in the past year. But BMA vice-president and associate general counsel Michel de Konokly Thege, who has headed investigations into their launch, said it is still an open question to determine if there is sufficient long interest from potential users.

One of the ways investors currently take positions on corporate bond indexes is through total return swaps on an index with a dealer. But that market is expensive for investors. “From a dealer standpoint, you want to get two-way flow in these kinds of markets and the index swap market has tended to be a one-way market. It's often difficult to get two counterparties who want to take the opposite sides of the swap at the same time,” said John Tierney, global head of credit derivatives research and strategy at Deutsche Bank in New York.

Tierney said because such a small share of outstanding corporate bonds trade on an exchange, pricing would be a major issue in seeking to develop corporate index bond futures. Tierney said he would expect any index futures contract in the US to contain at most 100 credits, or bonds with a minimum issue size of $500 million. “I think that's in the right ballpark. Those are the only securities that I think you could get solid prices from on a daily basis,” said Winkler.