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, as 10-year yields surged upwards of 4.3%.
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.”