The Unwinding of Leveraged Bond Trades That’s | Bonds & Fixed Income

Last week, closely leveraged bond trades had been unwound in a spectacular fashion.

And whereas the worst may be behind for now, I don’t see a structural repair to this bond market imbalance.

There are two very fashionable, closely leveraged trades in bond markets: swap spreads and foundation trades.

Both contain going long the money Treasury bond, and going short one thing towards it: the idea trades makes use of the Treasury future as short leg, and the swap unfold makes use of rate of interest swaps.

In each instances, the trades contain a giant use of leverage as a result of the acquisition of the money Treasury bond is financed utilizing the repo market: for a $100M trade in foundation or swap spreads, as a consequence of repo market funding hedge funds should solely use a tiny portion (~2-5%) of the needed capital to enter the transaction.

Let’s deal with the swap unfold trade for a second.

As long as repo markets stay orderly, buyers can use it to fund purchases of , pay a fixed 30-year rate of interest swap towards it and earn a whopping 90 (!) bps per yr in ‘’swap spreads’’ – see chart under.

But why on earth would buyers be capable of earn such a premium on US authorities bonds?

It’s as a result of of regulation and the growing provide/demand imbalance downside in US Treasury markets.

Bank regulation has crippled the flexibility of market makers to warehouse dangers, which implies their means to soak up giant issuance of Treasuries on their steadiness sheet has diminished.

On high of it, Treasury departments of US banks are penalized for proudly owning great amount of Treasuries from rules just like the Supplementary Leverage Ratio (SLR) which don’t exempt USTs from its calculations.

All of that is occurring at a time when the provision of US Treasuries has dramatically grown as a result of of persistent funds deficits, forcing sellers to swallow bonds at auctions and testing their limits.

Given the provision/demand imbalance, the marginal purchaser of US Treasuries tends to be the leveraged hedge fund which will get concerned in foundation or swap unfold trades and calls for a hefty premium as compensation.

And this fragile system holds till it doesn’t.

In the final 10 days, a number of hedge funds had been hit by margin calls given turbulent markets.

To meet these margin calls, they needed to de-risk their portfolios and promote each asset they may – together with Treasuries.

As Treasuries bought caught within the deleveraging mania, foundation trades and swap spreads suffered.

The first stop losses in these extremely leveraged trades had been hit, after which a self-fulfilling VaR shock occurred.

All hedge funds concerned in the identical trade needed to deleverage on the identical time with out a marginal purchaser of final resort.

Ouch.

And it’s not clear how this downside will get structurally fixed – so watch out!

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