Over the last decade, as rock-bottom interest rates depressed returns on fixed-income assets, the alchemists of Wall Street came up with a solution for investors who needed fatter yields: a whole series of complex products that spun extra basis points out of comatose markets.
Now, amid the worst bond rout in at least five decades, firms have been scrambling to hedge their positions, piling into derivatives that benefit from higher volatility as they seek to limit the damage.
In the process, they’re adding fuel to a fire that’s already sent one measure of rates volatility to near the highest level since the global financial crisis -- outpacing the violent swings in both stocks and currencies. At a minimum, it’s raising the stakes for bond traders, multiplying their chances to both make quick scores and take losses in a market that’s been whipsawed all year by the most aggressive Federal Reserve interest-rate hikes in a generation.
And for some, it’s prompting concern that structural positions embedded in the $24 trillion US government bond market could trigger unforeseen consequences, not unlike how liability-driven investment strategies helped worsen the UK gilts selloff last month.
“A lot of this previous issuance from a low-rate, low-volatility environment is still out there and needs to be hedged,” said Michael Pintar, head of US flow strategy and solutions at Societe Generale SA. “That’s creating a feedback loop.”
It’s not as if volatility markets have needed extra juice this year.
Surging Treasury yields have prompted investors to lessen their bond risk by buying derivatives -- including short-maturity options on interest-rate swaps -- that gain from rising rates. This, in turn, has fueled a desperate hunt among dealers for long-volatility bets to hedge their own exposure, according to Danny Dayan, chief investment officer at Dwd Partners, a macro hedge fund.
The one-sided nature of the market helps explain the dramatic ascent of the MOVE Index this year, which measures the implied volatility of Treasuries via options pricing. Last month it breached 160, near the highest since the aftermath of the financial crisis. Even after sliding to 128 on Monday, it’s still almost double its five-year average.
Low-Vol Wagers
But positioning around higher rates can only explain part of this year’s dramatic Treasury moves.
Exacerbating the swings are hundreds of billions of dollars of volatility-driven products, market watchers say.
Simply put, they’re side bets on the ups and downs of bond yields. Over the past decade, investors desperate for returns snapped them up, wagering markets would stay tranquil. Banks, of course, were all too happy to engineer another source of revenue.
The wagers were seen as a sure thing -- until they weren’t. As bond yields soar, investors are sitting on deep losses. Meanwhile for the banks, which were supposed to hedge themselves so they’d come out roughly even on these side bets whichever way the market moved, Treasury swings have become more extreme than they anticipated.
In fact, surging rates are now forcing many dealers to position against even higher volatility, just as the rest of the market is doing the same.
“You get through an inflection point and dealers have to buy volatility,” said Vineer Bhansali, founder of LongTail Alpha LLC and the former head of analytics for portfolio management at Pacific Investment Management Co. “There’s a lot of stuff that has happened that makes me believe that we are already on the precipice of a free fall -- these structures being just one factor.”
Many of these volatility-driven products -- with impossibly obscure names like corridor notes, fairway bonds and range accruals -- hinge on rates remaining within preset trading bands.
Some range accruals -- a product with an estimated $40 billion outstanding -- were linked not just to yields remaining low, but also to the shape of the Treasury curve, which is typically upward sloping.
As long as that remained the case, the holder of the product collected coupon payments. On the flip side, to hedge their exposure, dealers sold options that would likewise benefit from a positive term structure.
When the yield curve first inverted earlier this year, many dealers no longer had to make the interest payments on the notes. But as the yield premium of short-dated debt continued to climb relative to longer-dated bonds, the options they had sold became the problem, breaching key thresholds wherein they turned increasingly profitable for the buyer.
In essence, they were losing more on their hedges than they were making on their long-vol exposures. To protect themselves, dealers started buying more volatility, said SocGen’s Pintar.
Others note that changes to debt supply dynamics are also exacerbating rates swings.
Take the once-booming Formosa-bond market. These dollar denominated notes (there’s over $200 billion outstanding) sold by global banks to Taiwanese insurers are callable, meaning investors were effectively selling an option on interest rates to the issuer, which pushed down volatility. With higher yields now up for grabs everywhere and dollar hedging costs surging, Formosa sales are on track to reach a eight-year low, removing a long-time ballast for the market.
“The supply has dried up,” said Amrut Nashikkar, a rates strategist at Barclays Plc. “At the same time, demand for volatility has gone up because being long vol has been a great trade for the past couple of years and there’s uncertainty about where the Fed will go.”
For some, concerns are mounting that more pain could be on the horizon, with investors continuing to buy volatility as the Fed boosts rates and dealers increasingly forced to hedge their positions. Just last week, swaps traders boosted expectations for how high the Fed will have to take rates to 5.25%, a level almost unthinkable just months ago.
Recently UK pension programs were caught wrong footed when derivatives used to profit from falling government bond yields backfired as rates spiked. Margin calls fueled the forced selling of gilts, which drove yields even higher, and in turn increased the collateral payments pension programs needed to make. Only intervention by the Bank of England halted the cascade.
While LongTail Alpha’s Bhansali doesn’t see a structural risk on the same order of magnitude in Treasuries, he nonetheless sees the potential for problems ahead.
With the yield curve inverted and the MOVE index elevated, it “basically is a perfect set up for a VIX-like debacle in the rates market,” said Bhansali, referring to the infamous 2018 episode in which the gauge of US stock volatility unexpectedly surged. “It’s going to accelerate before it stops.”
Though others aren’t as gloomy, most agree that higher rates volatility is here to stay.
“Volatility is fundamentally repricing for the new world we are headed toward, which is a higher rate environment with more uncertainty around inflation,” said George Goncalves, head of US macro strategy at MUFG. “The dealer volatility hedging related to past structures they sold adds fuel to the fire of the higher volatility environment we are in now.”
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