Global Rates - Increasing risk of CTD switches in UST and Eurex futures

Khagendra Gupta (0:03)

Hi, and welcome to At Any Rate, JP. Morgan's Global Research Podcast, where we take a look at some of the drivers behind the biggest trends and themes across fixed income currencies and commodities market.

I'm Khagendra Gupta from Interest Rate Derivative Strategy in Europe at JP. Morgan, and today I'm joined by my colleague, Ipek, Head of US Interest Rate Derivative Strategy, to discuss how recent relentless increase in yields and rates volatility has increased the risk of futures CTD switches.

Ipek, welcome to this podcast. It has been a while since we have done a futures-related podcast, and I'm looking forward to the discussion regarding the recent development along this front. Now, let me begin by reminding our readers that across several US futures and Eurex futures, current CTDs have become less dominant, and in some cases they have already switched. So Ipek, what has changed this? We have gone through years in the past where the CTDs have been extremely dominant and wouldn't budge under reasonable yield or curve scenarios. So what do you attribute this dynamic to?

Ipek Ozil (1:09)

Yeah, I mean, that's a great point, Khagendra. And first, thanks for having me on this podcast to talk features. So yeah, switch optionality has become a factor in the longer data contracts, but mostly in, I guess, like the US and the W1 contracts in the US. And as you alluded to, it's because of the continuous increase in yields since the beginning of the year. So for example, if you look at the 30-year yields, they were around 4.8% at the start of the year, and now there are 80 basis points higher. So of course the increase in yields is due to a variety of factors. You have inflation expectation, Middle East conflict, Fed expectations repricing higher, and now the fact that we're likely in a hiking cycle and also change to the growth side of the story has come into the picture. So all of that to say, yields are higher across the curve, volatility is higher, and these dynamics have an impact at mostly in the US basket, as it is the largest basket that we have, as it spends roughly 15 to 25 years of maturity. Currently, there are a lot of bonds that are eligible to be delivered in this basket, from high coupon bonds to low coupon bonds.

It is also interesting because we're at this very interesting period.

So Treasury Futures uses what's called the conversion factor to basically account for the coupon differences by pricing what each bond would be at a 6% yield to maturity from first delivery day of the contract month. So this 6% was chosen by the CME, and it's been in place since 2000

So with the increase in yields, we are basically near 6% levels. And what happens if you actually get to 6%? And what that means is all of the bonds will look roughly similar in terms of price when you adjust for the conversion factor. Of course, that will not be the same fully because there are a lot of bonds in the basket and they have a spread to the on-the-run, say 30 year. But it will be very interesting when that happens because all the bonds will be kind of equi-cheap. And just for reference, the last time 30 year yields were near 6% was actually back in 2000 when CME introduced this change.

Khagendra Gupta (3:47)

OK, so it's essentially a yield level story then. I do have two follow up questions for you on this though. First, what are the implications for CTD switches?

To be specific, if the Treasury CTD switches, will there be, for example, the US CTD switches, will there be meaningful change in the DVO-1 and consequently the hedging behavior by investors? And second, do you think the market is correctly pricing with optionality? Or do you see like any relative value or basis of opportunity?

Ipek Ozil (4:23)

Yeah, so at higher levels, if yields were to continue to increase, there is a chance that you can switch to a lower coupon, higher factor adjusted duration bond. So what that means, the futures duration could extend and that could have an impact on hedging behavior by investors. But option adjusted BPVs already reflect this somewhat. So if investors are using option adjusted BPVs, then the hedging impact is likely to be less.

In terms of market pricing, based on our option model, we do think the market is underpricing this optionality a little bit in the US. So if the yields were to increase or the yield curve would steepen, the basis could widen and price is more optional. So there could be a little bit of opportunity there. But as of yesterday, we were looking at relatively two ticks of mispricing, so not that much.