It’s been more than a decade since the London International Financial Futures Exchange (now NYSE.Liffe) quietly laid its Buono del Tesoro Poliennale (BTP) Italian Treasury bond futures contract to rest after the euro made it obsolete. Two years ago, Eurex dug it up and pieced it together to create a successful "new" product.
"From 1997 to 2007, anyone could hedge their Eurozone sovereign exposure with the bund, bobl and shatz," says Ludvino Silva, a former debt manager for the Portuguese government. "You had a premium charged to non-German debt, but that was mostly based on liquidity and other issues — not to default risk."
That began to unravel in 2007 with the advent of the credit crisis that sparked today’s sovereign debt crisis. Eurex responded by bringing the BTP back to life — first with futures on the 10-year component in September 2009, then with a 2-3 year component one year later and finally with a five-year component in September 2011. The new BTP futures contract closed out August with open interest of 37,000. Volume averaged nearly 490,000 per day after two months that saw the 10-year BTP futures plunge more than 10 handles in July — from just above 108 to just below 98. It then soared back up to over 106 in August, mostly on the strength of one five-handle day. By September, it was spiraling downward again.
It adds up to more than €10,000 per contract on the first drop and €8,000 on the rebound, with more apparently to follow — and the ride, at times, has been even wilder for those spreading the BTP against the German bund. On Labor Day alone, the yield on the 10-year bund fell 15 basis points, to a record low of 1.85%, while BTP yields rose 28 basis points, to 5.54%.
You could have made money by spreading bunds against BTPs on Eurex, or you could have gone long futures on the Germany-Italy sovereign yield spread. The CME Group launched this family of 12 bond pairs in May, and dubbed them "Sovy Futures" (See "" on last page).
Italian family
BTP futures were launched to provide a benchmark for non-AAA government debt across the Eurozone, and Nadja Urban, who led Eurex’s BTP futures development initiative, says the exchange has no plans to add more contracts to capture even lower-grade sovereigns.
"Core countries like Germany and France are both AAA, and some smaller countries also are AAA, like Luxembourg, Austria and the Netherlands," Urban says. "All of these can be hedged with the bund, bobl and shatz. Then you have the non-core countries that have low beta — the AA countries, like Italy and Spain — and these can be hedged with BTP."
Then come the truly problematic countries: Portugal, Ireland and Greece.
"These are non-core with high beta," she says. "Their secondary markets are not tradable at the moment, and there is no one to make a market, so it’s almost impossible to launch a futures product on them."
For that exposure, you’ll have to look to credit default swaps.
"Risk of these countries is almost all credit risk," she says. "The price discovery is not done in secondary cash markets, but in the credit market."
The bulk of the contracts’ users come from Italy and Spain, with heavy spreading between the BTP and the bund.
"The biggest days in BTP futures have come on days when the BTP-bund spread moves the most," says Gustavo Baratta, a BTP market maker for Banca IMI, the investment banking subsidiary of Intesa Sanpaolo Group. He adds that the instrument has attracted hundreds of small traders who already are active on Borsa Italiana’s Mercato Obbligazionario Telematico (MOT) market, making it more liquid than it appears.
"This means that BTP futures have traded in one and two lots, so we’ve seen a lot of iceberg orders — where you come in to sell 100 or so but only show, say, three or four," he says. "A lot of people who are used to the huge volumes of the bund are afraid of coming to BTP with any size, but I think they’ll find it’s quite doable."
He warns that the market can behave erratically when new bonds are introduced near delivery time. This mainly is because any new bond issues that are large enough to be recognized as deliverable are likely to become the cheapest to deliver, and the Treasury isn’t always good at telegraphing that size. In 2010, Eurex lowered the threshold from €10 billion to €5 billion to reduce uncertainty, but the problem persists.
"We’re going through this now with the September expiry," he says. "The Italian Treasury issued new 10-years. In the market, the new issue would be big enough to qualify as cheapest to deliver. But then it became apparent that wasn’t the case, and that the cheapest to deliver would be the September 2021, instead of the March 2022. When that happened, futures had an uptick of half a figure."
The Sovy universe
The CME’s Sovy contract was launched in May 2011, and looked at first glance like a sure-fire winner. While Eurex’s BTP contract offers exposure to the entire yield curve of one non-AAA government and the absolute-risk on the short- mid- or long-term segment, the Sovy futures offer relative exposure to just the 10-year spread, but across several governments. The contracts offer outright exposure to twelve interest-rate spreads on one platform and one clearinghouse, and they are priced in a way that is simple and direct.
The contract is four months old and has yet to gain much liquidity. The exchange attributes this to the summer’s epic volatility in Eurozone government bond markets.
"Because of the novelty of this contract mechanism, we decided it would be a good idea to give our market makers the opportunity to put up prices and become accustomed to it in the knowledge that customer flow will materialize later," says Fred Sturm, director of financial research and product development at CME Group.
Many traders, however, said the contract was too novel. Several said they were leery of the cash settlement.
"Yield spreads are cash settled, and that’s a problem because there’s no official fixing in the European government bond market," says one. "Most of the volume is over-the-counter, so there is no transparency, so people don’t trust them."
Mike Kamradt, director of interest rate products at CME Group, says the settlement mechanism is as transparent as any other because it’s based on the median price of bonds in the market. He believes traders will take to it as they come to understand the product.
"What’s in the reference bond baskets — and how the reference bond baskets are determined — is completely transparent to everybody," Kamradt says. "For example, to be a reference bond, an issue has to have at least two billion outstanding, it has to have between eight-10 years of remaining term to maturity, etc."
The exchange obtains all reference bond prices from Interactive Data, the designated third-party valuation service, and the product brochure describes a detailed settlement process.
"On the Sovy futures contract’s last trading day, Interactive Data furnishes to the exchange a valuation for each reference bond, for standard settlement (T+1 for US and UK, T+3 for all EU), based on government securities market activity between 3:00 and 3:02 p.m. London time," the exchange says. "For each reference bond, the exchange converts price to yield. For each sovereignty, the exchange then computes the median of reference bond yields. For instance, the representative yield for UK is the median of yields to maturity on all gilts that are admissible as reference bonds, while the representative yield for Germany is the median of yields on all Bunds that are eligible to stand as reference bonds. The exchange uses these median yield values to calculate each Sovy contract’s final settlement price."
Kamradt says the exchange has signed up several market makers. Down the road, he says, they even may begin adding new pairs. Within Europe, they’re considering Spain, and beyond Europe they are looking at North American and Latin American bonds like those of Canada, Mexico and Brazil, as well as Pacific Rim bonds like those of Japan and Australia.
"All of these issuers have well-articulated fiscal mechanisms, orderly bond issuance and well-organized secondary markets," he says. "As liquidity builds in these contracts, there are plenty of directions we can take this."
Bonds behaving strangely
Anyone trading bonds these days should be prepared for a wild ride — not only in terms of direction, but also in terms of liquidity, with bid/offer spreads widening and contracting erratically.
"The market is in uncharted territory," says John Serocold, head of the International Capital Markets Association’s secondary market practice activities. "Every set of macro numbers that comes out now is subject to all sorts of different views, and that means if you’re going to carry inventory and act as a two-way trader, you have to make a wide spread to protect yourself."
He cites a litany of issues beyond the headlines that are creating chaos in cash markets — from contradictory messages to frequent personnel shifts to the changing composition of the bond market.
"Because people who trade cash are finding it difficult to make sense of the fundamentals, that’s going to lead to volatility, and that volatility itself may be volatile," he says. "If the market itself is a bit bipolar, when it’s depressed, it won’t do anything, but when it’s manic it will be all over the place."
Baratta and other traders say that already is happening.
"The cash is less liquid than it used to be, and the first bonds affected are the after runs," he says. "We’ve seen more polarization than in the past, so the benchmarks and underlyings are more liquid, but the after runs are less liquid."
This lack of liquidity has created a negative feedback loop that keeps short-term players out of the market because they begin to fear slippage.
"Italy used to have a liquidity premium just because of the sheer size of its debt," he says. "It’s the fourth-largest debt market in the world, but this liquidity premium has been eroded because of the illiquidity. Now, it’s almost completely vanished."
This has helped make the BTP a success.
"We still have a curve that is quoted all day long on every single bond," he says. "When cash markets became illiquid, futures looked more attractive."
Splitting the differentials: How to read a Sovy quote
Like many other interest rate futures that trade on CME’s Globex, daily settlement prices for Sovy futures are determined by the exchange on the basis of actionable bids and offers as reflected on CME Globex. Sovy daily settlement prices are determined at 3 p.m. London time, or 9 a.m. Chicago time.
If the market expects the yield differential between Germany and Italy to be 3.5% (350 basis points), then Sovy futures due for delivery that month would be quoted as that differential plus 100, or 103.500. If the differential is negative, the price will be below 100. The contract price indicates that market participants broadly expect the spread between the median yield on Italian Reference BTPs minus the median yield on German Reference Bunds to be 350 basis points per annum when the contract expires on Dec. 7.
Suppose one day later you sell the contract at 103.600. The price indicates that market expectations have shifted so that the Italy-Germany yield spread for forward settlement on Dec. 7 is now seen to be 360 basis points. Because you are long the contract, you effectively are long exposure to the forward yield spread, and you have earned 10 basis points. Because the currency unit for Germany-Italy contract is the euro, and because the contract is sized at 100 euros per basis points, your purchase and subsequent sale of the contract has earned you €1,000:
€1,000 = 1 contract x 10 bps x 100 euros per bp per contract.
