Home ListingMarch 11, 2014

The New Weapon in the LDI Arsenal

<em>An ultra-long government bond future offers novel synthetic exposure to gilts, but will the market care enough to make it viable?</em>

Reported by Featured Author

(March 11, 2014) — The latest 30-year gilt future, issued by NYSE Liffe earlier this year, is a better fit for pension funds’ liability-driven investment (LDI) frameworks than the over-the-counter (OTC) equivalent, according to UK consultants Redington.

This new future provides leveraged exposure to gilts in much the same way as a total return swap (TRS) or gilt repo trade, but has claimed to outperform the by changing the credit counterparty to an exchange, rather than a bank. Furthermore, it is said to be cheaper than a TRS to execute and trade out of, and boasts standardized terms for transparency and tight pricing amongst participants.

However, the success of this future depends on how many participants take it up, as Director of Manager Research Kenny Nicoll explained.

“The main challenge is finding natural buyers and sellers to provide sufficient liquidity, as shown by trading volumes of German and US ultra-long futures. Against this, hedge fund managers should like the credit and duration properties while banks are likely to be long gilts so looking to sell the future, both adding to market liquidity,” he wrote.

“The other big challenge is the capability of the future to meet LDI hedging needs. With fixed maturity dates, futures cannot provide as exact a hedge as OTC products for LDI hedging.”

A concern has also been raised regarding so-called cheapest-to-deliver risk. As the future is deliverable on expiry against a basket of underlying gilts with different maturities, this risk would arise as the cheapest gilt can change at short notice.

“This means the duration of the futures contract will change, so the number of contracts will need to reflect the change in duration relative to a client’s hedging benchmark,” Nicoll explained.

Finally, for investors which are not set-up to trade futures, or are unable to post initial margin/cash as variation margin, exposure to the 30-year future could also become available from banks through total return swaps, as currently exists for 10-year futures.

“Ultimately, meaningful volume and interest from the wider investor community will determine whether or not the ultra-long future becomes a liquid and successful product,” Nicoll concluded.

The full report can be found here.