Hedging against the unwind of QE in Europe

Peter Lee
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Amid rising uncertainty over when the ECB will end quantitative easing and the likely extent of rate rises in the eurozone, the realization dawns that some investors could suffer devastating losses.

At the end of August, Schroders became the latest investor to upgrade its growth forecasts for the euro area – to 2.1% for 2017, up from 1.8% previously and to 1.9% for next year up from 1.8%.

As fears over rate rises grow, ECB president Mario Draghi affirmed at the Kansas City Federal Reserve shindig at Jackson Hole that: “The global recovery is firming up.” Draghi was careful in public to point out that while the US recovery is more advanced, in Europe “the consolidation of the recovery is at an earlier stage”. But minutes of the July meeting of the ECB governing council, published in mid-August, show at least one unnamed member arguing that economic expansion is increasingly self-sustaining and hence has become less dependent on monetary policy accommodation.

Azad Zangana, senior European economist and strategist at Schroders, says: “We continue to expect the ECB to extend QE into 2018, albeit with smaller monthly purchases and eventually being faded out over the year.” He suggests the ECB could announce a tightening of policy as early as this September.


Decouvelaere, SG CIB

There’s no consensus on this though. The most recent ECB minutes also showed agreement on the governing council that inflation will only converge on the ECB target of close to, but just under, 2% gradually and that doing so at all remains conditional on a very substantial degree of monetary accommodation.

In late August, rates strategists at Bank of America Merrill Lynch, saw renewed hopes in Europe of a goldilocks outcome of improving growth but with continued ECB support for bond markets. “Investors are taking advantage of the benign backdrop to harvest carry. Periphery longs have been re-built, bringing positioning back to October 2016 levels, with sentiment bullish for the first time since September last year.”

Bond investors seem to feel they can still enjoy the best of all possible worlds. Are they fooling themselves?

Euromoney speaks to a rates strategist at another US firm who says: “There is a degree of complacency in Europe that rates will not rise soon and only slowly when they eventually do. If they do rise soon and rapidly, then some investors ­– notably banks but others as well – stand to lose an amazing amount of money.” Some investors are looking to hedge against this tail risk while volatility is low and so options are cheap. But truly risk-free yields are also very low and leave almost no income out of which to buy protection, even if it does look theoretically cheap.

Looser policy = more risk

It is an irony of the bizarre market valuations imposed by extraordinary central bank policy that fixed income investors have to take more risk, at the very least by extending duration if not also by taking on periphery credit risk, just to generate the income to afford protection.

Thomas Decouvelaere, deputy head of pricing and development in Europe, in charge of fixed income at Societe Generale Corporate and Investment Bank (SG CIB), talks through one recent trade put on with a big European pension fund that had been building a portfolio of bonds and wanted to hedge the underlying interest rate and duration risk.

“The conventional and by far the easiest way to hedge rate risk is to go short the 10-year Bund. But the cost of borrowing in the repo market is very high. Another approach is to enter into a swap to pay fixed and receive floating, or else, to buy a payer swaption. But timing when to put on such a tactical trade can be difficult. This has been a concern for over a year among European investors and the subject of intense discussions. The cost of rolling Bund, swaps or swaptions for five to 10 years can possibly eat up a large chunk of your portfolio returns.”

Decouvelaere says the firm has devised a new approach that is convincing more and more customers. “We have been able to show that a more systematic approach, putting on a series of payer swaption trades can be a much more cost effective hedge. Investors can buy a series of at-the-money payer swaptions and partly finance those by selling out–of-the-money swaptions. The net effect will be to protect against the first 100bp rise in rates in any given year but with protection capped out so that investors retain risk of higher rate rises.”

He says: “That first rise in rates of 0-100bp in a year is the risk that investors most want to protect against. A rise of greater than 100bp in a year might be more damaging but is also much less likely to happen.”

The house view at SG CIB is that 10-year Bund yields will roughly double between now and the end of the year, rising from 38bp in late August to around 75bp.

Decouvelaere says: “We have structured this with a five-year tenor. For those clients concerned about executing all the underlying swaptions trades themselves, we can take on the operational burden, replicate the swaptions into an index and provide clients a single total return swap on that.”

Cost of carry

The danger for investors that grow concerned about duration exposure and put on interest rate swaps to hedge without fully analyzing the cost of carry is that when they see how expensive that protection is to roll over, they may take it off again just before rates do start to move against them.

Decouvelaere suggests that the structure suits asset managers and pension funds subject to mark-to-market accounting. For insurance companies and other investors subject to accrual accounting, rate hedges will typically be done on the asset side.

“This is for the bank to repackage a portfolio of underlying bonds to fund payments on an MTN where the investor receives a fixed coupon for the first few years of its life which can switch to a floating rate based on the constant maturity swap that will go up if rates rise. Again, the cost of buying that protection can be partially offset by selling a cap on the floating rate to be received if rates do rise.”

After such a long period of low rates, hedging against eventual rises seems obvious but requires investors to think in new ways. Are investors being convinced by these ideas? Decouvelaere says: ‘There are a few quite sophisticated clients who get it very quickly. Some see the benefit of the reduced cost but worry about the operational complexity and for them we can take that on and handle the underlying individual transactions. A lot of investors, however, are doing nothing.”

Florian Moosauer, head of rates sales for Europe ex-France at SG CIB, says: “This has been an exciting time for us. The bank is known for its derivatives DNA, but in fixed income had provided essentially an execution platform to clients. But since integrating all asset classes and teams, from flow to exotics, into what we refer to as One Mark – we have seen our firepower increase significantly to provide advice and solutions to our clients combined with strong execution capabilities.”

Market share and revenues are going up. “Our growth in FICC market share in the first half of 2017 was 3.4%, which comes after significant growth of 16.2% in 2016,” Moosauer says.

A number of competitors have pulled back from complex derivatives. Moosauer adds: “Some banks have exited swaptions and exotic OTC derivatives. Not only have we remained committed to these markets, we have added resources, increasing our ability to help clients prepare for any sudden reversal in the bullish sentiment around European bonds and hedge duration and duration volatility.”

The bank’s swaptions business grew 140% in 2016.