Hedging against rate rises in Europe
If European bond investors want to protect against rising rates, they must first put on more risk.
Even if it doesn’t taper QE or raise rates until next year, the European Central Bank could announce the timetable for a reduction of stimulus as early as October.
Markets have not yet priced this in. In late August, rates strategists at Bank of America Merrill Lynch saw renewed hopes in Europe of a so-called goldilocks outcome of improving growth but with continued ECB support for bond markets. Investors have been harvesting carry, going long periphery markets.
Are they fooling themselves?
There is certainly 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 vast amounts.
Those looking to hedge against this tail risk while volatility is low and options are cheap, find that low-risk yields are so meagre they leave almost no income with which to buy protection, even if it does look theoretically inexpensive.
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. Even then, they have to be ingenious.
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. The cost of rolling bund swaps or swaptions for five to 10 years can possibly eat up a large chunk of portfolio returns.
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 start to move against them.
Bankers at Société Générale Corporate and Investment Banking have persuaded some investors to put on a series of payer swaption trades as a 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 100 basis point rise in rates in any given year but with protection capped out so that investors retain risk of higher rate rises. The house view at SGCIB 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.
After such a long period of low rates, hedging against eventual rises seems obvious but requires investors to think in new ways. A few quite sophisticated clients get the cost effectiveness of such a hedge very quickly.
A lot of investors, however, are still doing nothing.