Understanding Credit Curves: Revealing the Hidden Risks in Your Financial Strategy

The US fixed-income market has seen big changes in how stable it seems. Events like a sudden rise in interest rates in September 2019 and a big sell-off in March 2020 have made people worry more about risks. These events made regulators require that Treasury and repo deals go through clearinghouses. This move led to fewer hedge funds taking part in the market.

But, the real issue is a long-standing problem with the hedging market. This could cause a big failure in managing risks in fixed-income.

Key Takeaways

• Credit curves play a crucial role in revealing hidden risks in your financial strategy.
• Recent market events have highlighted the need for a deeper understanding of fixed-income market stability.
• Spread curves analysis can uncover potential pricing inefficiencies and hidden value opportunities.
• Integrating environmental, social, and governance (ESG) factors into investment strategies is becoming increasingly important.
• Green bonds offer a unique opportunity to fund ESG-related projects while satisfying investor ESG criteria.

The Evolving Perception of Fixed-Income Market Stability

The fixed-income market was once known for its stability. But recent years have shown otherwise. In September 2019, interest rates on overnight repurchase agreements (repos) suddenly jumped. This caused the Federal Reserve Bank of New York to add $75 billion in liquidity to calm the market¹.

Then, in March 2020, the COVID-19 pandemic caused a big sell-off in securities. The Fed responded by buying over $1 trillion in securities to bring things back to normal¹. These events have made people question the stability of the fixed-income market and how well regulatory policies work.

Recent Events Highlighting Market Vulnerabilities

Experts point to the actions of hedge funds in “basis trades” as the main cause of market instability. They say liquidity is the big problem in the Treasury market¹. But, there might be more to it. The market could be facing a deeper issue: a long-term problem with hedging that threatens the whole system¹.

The Misdiagnosis of Underlying Problems

Because of these issues, regulators have made new rules for Treasury and repo transactions. They want these to go through clearinghouses to make the market more stable¹. But, these steps might not fix all the problems. We need a better understanding of how the fixed-income market works, including the role of hedge funds. This is key to finding real solutions for market stability.

“The fixed-income market, once seen as a bastion of stability, has faced a series of unsettling events in recent years.”

Broadening the Perspective: Investment Funds as Vehicles of Market Inefficiencies

To find the hidden risks in our financial plans, we must look wider. We should see investment funds not just as single entities but as tools reacting to market changes. Investment funds, both traditional and alternative, move inefficiencies and chances from one market to another, like from derivatives to Treasuries cash market².

Seeing market inefficiencies through the actions of fund managers helps us understand their impact. For example, traditional funds moving into futures can make market volatility worse². Also, alternative funds using a lot of leverage for trades can lead to liquidity problems².

Regulators have noticed how fund managers, both traditional and alternative, affect the US Treasury and repo markets’ stability². They point out that fixed-income managers using futures can make market risks and inefficiencies worse².

Seeing investment funds as tools that move market inefficiencies helps us understand the risks in our financial plans better. This view is key for making stronger risk management strategies².

“Price distortions frequently arise pursuant to major information or price shocks that create confusion or panic in the market.”³

The financial world is always changing, and we must see investment funds as active players in the market structure and its inefficiencies. This view helps us navigate the complex risks and chances in our financial systems².

Risks Hidden in Fixed-Income Risk Management Practices

Bond mutual funds are a big part of the US Treasury market. They face a big challenge – managing interest rate risk. To handle this, they often use derivatives like options and interest rate swaps. But, these tools might not work as well as they used to⁴.

Bond Mutual Funds and Interest Rate Risk

The market for Treasury options is getting smaller, and swaps are mostly for short-term investments. This creates a big problem for managing risk – “duration drift.” It’s the part of the portfolio that’s not covered by derivatives because their durations don’t match the assets⁵.

Also, some risks are hidden by accounting rules that let bad hedges go unnoticed. So, bond mutual funds might be at risk from interest rates more than they seem⁵.

Duration Drift: The Unhedged Portion of Portfolios

Options and swaps can’t always match the duration of the bonds they’re meant to protect. This leaves bond mutual funds open to big risks from interest rates. These risks might not be clear from their reports⁵.

As the bond market changes, it’s important for investors to know about these hidden risks. Understanding these issues can help investors make smarter choices and deal with the bond market’s complexities⁴⁵.

“The inability of options and interest rate swaps to provide the exact duration match leaves bond mutual funds vulnerable to duration drift.”

The Shift Towards Futures and Its Impact on Basis Points

Fixed-income fund managers have seen changes in the options and swaps markets. This has led them to turn more to the futures market⁶. With shorter contracts and fewer options, they now focus on futures for their hedging strategies⁷. This change has made futures more in demand, raising the basis points hedge funds can use.

This shift affects many areas⁶. Yield spreads, measured in basis points, show market feelings and creditworthiness⁶. A 3% yield spread equals 300 basis points. It shows how one bond beats another.

Wider yield spreads mean stable economies. For example, a jump from 500 to 550 basis points signals stability.

The move to the futures market comes from wanting to reduce risks in options and swaps markets⁸. Interest rate swaps are now more popular for hedging, especially at the long end of the curve⁸. This change has been ongoing since the 2007-09 Great Financial Crisis.

Fixed-income managers are adjusting to these changes, affecting basis points a lot⁷. Hedge funds have added over $317 billion in Treasury holdings for basis trades since early 2022⁷. Short positions in Treasury futures by leveraged funds have also grown, reaching 2018-2020 levels⁷. This shift brings new challenges and chances for investors, highlighting the link between fixed-income and futures markets.

“The shift towards the futures market has been driven by several factors, including the desire to mitigate the risks associated with the options and swaps markets.”

credit curves: A Key to Uncovering Hidden Risks

Understanding credit curves is key in the fixed-income market. Here, hidden risks are common. One risk is the “cross-market basis trade,” used by hedge funds to make money from price differences⁹.

Understanding the Anatomy of a Cross-Market Basis Trade

Hedge funds use this trade by borrowing to buy US Treasury securities cheaply. Then, they sell US Treasury futures at a higher price. This strategy aims to profit from the price difference between markets².

Regulators worry that hedge funds’ high leverage in these trades could lead to sudden market changes. If this happens, funds might sell quickly, causing “fire sales” that could shake the market².

Regulators’ Perspective on Hedge Fund Arbitrage Strategies

SEC and Federal Reserve regulators see hedge fund withdrawals as market destabilizers. They believe fund managers’ actions increase US Treasury and repo market volatility².

Fixed-income managers moving to US Treasury futures has caused prices to differ from the underlying asset. This is known as “basis.” Regulators fear these strategies, aided by low or zero repo financing haircuts, could lead to liquidity crises².

As the fixed-income market changes, understanding credit curves is vital. It helps investors, managers, and regulators spot hidden risks. This knowledge can lead to a more stable and efficient market⁹¹⁰².

Conclusion: From Fund Behavior to Market Structure Inefficiencies

The problem with fixed-income risk management isn’t just with the funds. It’s with the market itself. Regulators focus on fund behavior¹¹, but ignore deeper issues. These issues come from the lack of swaps and options in the market. Not tackling these problems means regulatory efforts might not bring financial stability.

Looking into the Treasury market’s instability, we see how investment funds and the market interact. Market control by a few can mess up prices and cause market failure. This makes it hard for funds to manage risks well. Focusing only on funds¹² misses the big issues these funds face.

By looking at the big picture, we can find better ways to make the fixed-income markets more stable. Government actions, like antitrust policies, taxes, and subsidies¹¹, can help fix these issues. This way, we can reduce the risks in the complex world of fixed-income markets.

Source Links

1. Active Fixed Income Perspectives Q3 2024: The high road
2. A Safe Haven for Hidden Risks | Elham Saeidinezhad
3. Price Distortions | Macrosynergy
4. Private Credit: Characteristics and Risks
5. Section 7.1 Sensitivity to Market Risk
6. Yield Spread: Definition, How It Works, and Types of Spreads
7. Quantifying Treasury Cash-Futures Basis Trades
8. The bond benchmark continues to tip to swaps
9. Uncover Hidden Value in Credit
10. The Private Credit Playbook: Understanding Opportunities for Family Investors – Cambridge Associates
11. Market Failure: What It Is in Economics, Common Types, and Causes
12. The Firm and Market Structures