In their efforts to understand the growth of the basis trade in US Treasury markets, regulators have started looking at the other side of the trade – the asset managers buying ever larger amounts of Treasury futures.
Regulators have realized that asset managers have a preference for Treasury futures over Treasury securities in their investment portfolios, and this preference is strong enough to affect the pricing of Treasury futures. That in turn has created an incentive for arbitrage trading by hedge funds, in which they sell the futures and buy the securities.
To understand this preference for Treasury futures, the US regulatory community invited several money managers to speak on 26 September at the annual Treasury Market Conference, a one-day event held at the Federal Reserve Bank of New York. The conversation revealed that the need to manage duration is probably the most important factor driving the increased use of futures.
For fixed income investors, duration measures the sensitivity of an investment to changes in interest rates. The higher the duration, the more the value will fall if rates rise, and vice versa. For example, a bond with a duration of 10 years is much more likely to gain value if rates fall than a bond with a duration of only two years. For that reason, fixed income investors see duration as one of the most important risks to manage in their investment portfolios.
Scott Mixon, the chief economist of the Commodity Futures Trading Commission, set the stage with a chart based on CFTC data that illustrated trends in asset manager positions in Treasury futures since 2006. Over the last five years, the net value of outstanding positions has roughly doubled and now stands at record levels.
Source: Commodity Futures Trading Commission
David Rogal, head of total return and inflation portfolios at BlackRock, explained that the search for yield is driving many asset managers to invest in corporate bonds and other fixed income securities with credit risk because they offer higher yields than Treasurys. On the other hand, those securities tend to have relatively short maturities. That creates an issue for asset managers that measure their performance against a benchmark that includes a high percentage of medium-term and long-term Treasurys. Rather than buying Treasurys to match the weight in the benchmark, they use Treasury futures to replicate the Treasury exposure. That allows them to keep the credit exposure overweight that generates higher returns but still maintain the target level of duration.
Rogal noted that this replication strategy has a cost, but the cost is outweighed by the increased return from the credit overweight. He cited a presentation given in January to the Treasury Borrowing Advisory Committee, a quasi-official advisory committee, that estimated the financing cost at 40 basis points. In other words, asset managers are willing to pay 40 basis points extra for Treasury futures—and that spread creates the incentive for the basis trade.
Rogal mentioned several other reasons for what he called a "structural preference" for Treasury futures. Those reasons include the operational simplicity of using futures, restrictions that some customers have on using repo transactions as an alternative way to manage Treasury exposure and expense reporting standards that make repo trades appear more expensive than futures.
Those other reasons, however, are not as critical as the need for duration, according to Gregory Peters, co-chief investment officer at PGIM Fixed Income, the asset manager business operating within Prudential Financial that has $805 billion under management. Peters offered an example to show why. Suppose an asset manager decided to buy a triple-A rated collateralized loan obligation at an interest rate of 150 basis points over the SOFR rate. Using a Treasury future will cost 40 basis points, but it allows the portfolio manager to adjust the duration of the portfolio and still earn a net positive spread of 110 basis points.
"From an asset management standpoint, it's about the relative value opportunity around Treasurys," said Peters. "It just so happens that Treasurys don't offer a lot of relative value opportunities. We're just doing what we think is best as a fiduciary."
Peters noted that repurchase agreements, which involve the lending of Treasury securities, could be used as an alternative way to adjust duration, but he commented that there are "structural frictions" that hinder the use of repos. One of those sources of friction is the operational complexity of repos. He explained that if an asset manager opens up a new account with a dealer, there is no hesitation if the intention is to use futures. But if the asset manager wants to use repos, the dealer community reacts very differently. "That changes the whole dynamic," he said. "That changes the whole cost function that you get from the dealer."
Joseph Demetrick, senior vice president at MetLife Investment Management, described a similar dynamic in the life insurance industry. Due to the nature of the life insurance business, insurance companies have liabilities that can go out 30 years or more, he explained. These companies need to ensure that their investment portfolios have a similar duration.
"When we are constructing asset allocations, we are looking to achieve a portfolio that has the same cash flow dynamics and interest rate dynamics as our liabilities," said Demetrick, who is a managing director in the public fixed income division within MetLife Investment Management. "We are going to incorporate spread assets … into that asset allocation, and a lot of those [assets] will be shorter duration or intermediate duration. It makes it challenging to come up with an effective asset allocation match."
For that reason, many insurance companies look to the derivatives markets to adjust the duration of their portfolios. Treasury futures offer one solution, but insurance companies also use several other types of derivatives, Demetrick said, including interest rate swaps, Treasury bond forwards and Treasury bond total return swaps. The use varies depending on three main factors: hedge effectiveness, cost and financial statement impact. Forwards and total return swaps have advantages such as customization and greater flexibility in collateralization, he said, but futures are favored when liquidity is more of a consideration.
Pension funds are another important segment of the interest rate market. Like insurance companies and asset managers, they use Treasury futures to manage duration in their portfolios. David Eichhorn, chief executive officer and head of investment strategies at NISA, described how his company uses derivatives in the liability driven investment solutions that it provides to its pension fund clients. NISA manages $164 billion in derivatives for more than 200 clients in the pension fund industry.
Eichhorn said the typical pension fund will allocate around 40% of its investments in "risk assets," and they need duration to manage the risk in those assets. In the past, NISA relied mainly on interest rate swaps to achieve that goal, but it has stopped using them almost entirely, he said. The main reason was the introduction of ultra long bond futures at CME. Those contracts are based on Treasury bonds with at least 25 years to maturity, making them exceptionally effective as a tool for adding duration. But NISA also uses an increasing volume of repos, he added. Ten years ago, the firm did not have the ability to use repo effectively, but it has built out that capacity and now it does repos "day in and day out," he said.
The popularity of Treasury futures among asset managers has increased the cost of using futures, creating an incentive to use repos or total return swaps. In fact, Eichhorn said using ultra bond futures can cost as much as 100 basis points more than using repos or total return swaps. On the other hand, repos are operationally "far more intensive" for managers and custodians, he said, and it takes time to make customers comfortable with using repos. For that reason, he said it makes sense to add repos and TRS to the hedging tool kit when clients are "hedging in scale."
Metlife's Demetrick echoed Eichhorn's comments about operational considerations affecting the choice of hedging instrument. In particular, he pointed to the ease of establishing accounts with futures commission merchants (FCMs), the industry term for clearinghouse members that process trades in futures, compared to doing business on a bilateral basis with dealers.
"It is far easier to set up a futures agreement or a cleared swaps agreement with one or two or three FCMs, and then you have the ability to trade with a wide variety of counterparties," Demetrick explained. "To do [over-the-counter] derivatives trading, you are setting up individual agreements with an array of dealers. You have to negotiate those, you have to go through credit, and now with the uncleared margin rules you have to set up initial margin documentation and custodial accounts. If you are not already in position to do that, that is a large hurdle."
Mohit Mittal, chief investment officer for core strategies at Pimco, added another perspective on the use of futures. For his firm, the liquidity and anonymity of futures trading is an important driver of the decision as to which instrument to use for managing duration. Pimco manages more than $1.8 trillion in fixed income assets, making it one of the largest investors in fixed income markets in the world. When Pimco wants to make a large trade, it needs to consider the potential impact on prices. Futures markets concentrate liquidity in a centralized market, and the anonymous nature of trading makes it easier for Pimco to move in and out of the market without signaling its intentions.
"When we change views, and we have to execute in size, having futures allows us to implement that in more an anonymous manner relative to … having to go to a broker dealer and seek liquidity that way," said Mittal.
Earlier this year, research analysts at the Federal Reserve published a statistical analysis of positions in Treasury futures held by mutual funds using data from the Securities and Exchange Commission. The analysts estimated that mutual funds held roughly $500 billion in Treasury futures as of the fourth quarter of 2023, up 67% from the fourth quarter of 2020.
"The recent rise in mutual funds' futures holdings reflects both their increased demand for Treasury exposures and an increased preference for sourcing these exposures through futures," the staffers said in the research note.
