On the latest episode of the Schaeffer's Market Mashup podcast, Patrick hosts a roundtable featuring Jane Street’s Institutional Sales and Options Specialist Dave Kovtun, Cboe Global Markets’ VP Multi-Asset Product Development Dennis O’Callahan. and EMEA Derivatives Sales David Litchfield. The topic? The all-so relevant rise in bond yields. They discuss how investors can hedge risk tied to volatility and interest rates (5:50), what it means for corporate bonds (10:30), and what it all means for investor sentiment (16:32).
Transcript of Schaeffer's Market Mashup Podcast: March 18, 2021
Patrick: Ladies and gentlemen, welcome back to the Schaeffer's Market Mash up. Looking forward to a little bit of round table action today. Welcome back, Dave Kovtun, Jane Street's institutional sales and options specialist, Dave, how's it going?
Dave Kovtun: Good, thanks Patrick. Good to be back with you. And yeah, I feel like the market always saves something exciting for when we record it was election last time, but I'm excited to be back here today.
Patrick: Yeah, just for the record, you will be muted if there's any bangles slander.
Dave Kovtun: Hey, I got nothing against the bangles man. Niners fans, we can be friends.
Patrick: Alright, sounds good. I also have CBOE global markets, VP of multi-asset product development, Dennis O'callahan Dennis, how's it going?
Dennis: Good, thank you for having me join in this round table.
Patrick: Yeah. You know, you got to have a good Irish name on St. Patty's day, right? And last but not least, I have David Litchfield, EMEA director of derivative sales at CBOE. Litch, welcome on.
David Litchfield: Thanks very much. [Unclear 01:19].
Patrick: Alright, good to hear. It's been a pretty dramatic year for credit investors. And then 2021 started off with an even bigger bang as of last check 10, the 10 year treasury yield has reached levels, not seen since before the market volatility of March 2020 dating back to January, 2020, I believe. And then as of this recording, we have a fed meeting that I'm sure investors will be watching quite intently. It's kind of crazy to believe that it's been almost a year since COVID sent the VIX north of 80 Dave. I want to start with you. What did this past year teach investors about the value of fixed income ETFs and ETF options as a tool for investors?
Dave Kovtun: Yeah, amazing to think it was exactly yesterday. One year ago, the S and P 500 closed down 12% on the day and the vix finished above 82. It was like an all-time closing high, obviously a lot has transpired in markets since then. Market's recovering generally, but one of the big stories has been the role in continued emergence of fixed income, ETFs and ETF options. As far as lessons learned, if we go back to those most volatile days of March 2020, the fixed income ETFs again showed the resiliency of the ETF structure, not just as a way for investors to efficiently transfer risk intraday, but also as a vital means of price discovery. You know, for all credit participants, credit market participants at a time when so many of the underlying bonds just were simply not traded, in stressed markets you know, there's a lot to be said for listed continuously traded centrally clear transparent products like ETFs.
Ultimately I think it speaks volumes that the fed included fixed-income ETFs in their bond buying program. The BSM CCF, it's hard to think of a bigger endorsement than that. And then we got kind of towards the end of the year and another milestone, fixed income ETFs, collectively surpassed a trillion dollars in assets under management now, pretty amazing how that all played out. As far as on the option side. When we think about lessons learned from last March, I feel it was really a validation that fixed income ETF options, particularly high yield credit puts could be an effective hedge for investors. To think about the difference between a credit put like an HYG put and something like a s-p-y put, the HYG put it's much lower in absolute price terms. And that's a function of the volatility, the implied vol just key input to all option prices.
Fixed income tends to carry much lower implied vols than equity. Could be half as much, could be a third as much. However, you know, fixed income can sometimes experience drawdowns that are on par or at least close to those of equity indices making them kind of a higher leverage or better bang for your buck. And let last March was a perfect example you know, if you had bought like a two month out the money put in HYG dairy January, February, you're paying roughly about 4% implied vol. Well, a similar put in s-p-y was traded for about 12 vols, so about three times the pricing in vol terms, yet if you looked at the peak to trough drawdown, yes, equity did sell off a little more in excess of 30%, but HYG still sold off 20%.
You know a pretty severe drawdown so in terms of bang for the buck credit was actually a better payoff relative to cost. So that was a really interesting takeaway and I think it's one of the reasons investors have increasingly sought out credit ETF puts for portfolio protection. Now more recently equity and credit markets are very close to all-time highs. But it's all about interest rate volatility you alluded to it at the top and that's pushed so many into treasury ETF options to manage those risks where we're just coming off February 2021. It was one of the highest volume months on record in TLT options that we've ever seen.
Patrick: What specific strategy you think has evolved in the past 12 months. And where do you see that going possibly in the next 12 months?
Dave Kovtun: Volumes have definitely grown, but it's really been like a broadening out of strategies. When I was on the pod last time we were talking about the election, it was all about event traded. What we called event vault and how people were using SPX options to speculate and trade the event of the election and how you can kind of back out and imply moves. With today's fed meeting it's really no different, you can, except it might not be SPX that you want to focus on it might be TLTs that is definitely could have the most direct security when you're talking about the impact of interest rates. So people are bidding up these TLT options. At last check, the app the money straddle in TLT is about 2% of the spot price now that expires this Friday. So if an investor buys that today, they need an excess move of 2% in the treasury ETF, to show a profit between now midday Wednesday and Friday, that's a pretty substantial move for treasuries.
And that really shows you the respect the market has given this fed meeting. So definitely a lot of events strategies mentioned earlier, just in terms of the bang for the buck and just outright puts people have used outright put strategies in credit ETFs over the past year. Put spreads definitely have been adopted in mass; we're seeing some of the larger trades that you'll see in the products are put spreads. That's when an investor is buying like a near the money put and writing a further out of the money put, and they're cheapening their costs to frame. Some of that cost by writing the downside put, we'll still get in protection over a range of outcomes, just maybe not the tail outcome.
And then as the markets evolve, these are a long vol trades I'm kind of talking about so far, but you'll see shortfall trades. If an investor thinks, listen, I think this has kind of gone too far.
And I think rates might be range-bound for a time. Maybe I should look at selling a straddle or selling a strangle, collecting that premium now with yields as high as they are and the move that we've made. You know, I wouldn't be surprised if we saw put writers coming in, you know, thinking bond prices may have found some sort of low for now that yields may have found a high. Definitely could see shortfall trades like that. And then finally, some of the option traits that we see really aren't volatility trades at all kind of think of them as funding trades or synthetic trades, but borrowing the chairs historically and credit ETFs hasn't always been the easiest particularly a year plus ago. In stocks like HYG, ETFs like HYG, so investors can kind of replicate short exposure by buying a put and selling a call with the same strike price. And that's not really a play on volatility, that's really saying how can I use options to replicate a short and more recently the borrows become a little constrained again. And we've more volume kind of executed in that trade.
Patrick: Yeah, you weren't lying about saying there was a broad array of strategies being deployed in the past year it seems like investors are leaving no stone unturned. Dennis, I want to take it over to you. Can you unpack the relationship between treasury products and volatility performance?
David Litchfield: Yeah, there is a relationship, but it's not a simple relationship. Unlike the relationship between SPX and VIX on the equity side which have consistently strong negative correlations, the relationship between treasury products and treasury volatility is much more complex. At times, such as March, 2020 that we’ve been talking about a lot the 20 day correlation between the TLT ETF and VX TLT CBOs, 30 day volatility index based on TLT options was strongly positive, in the 0.85 range. As the price of TLT rose, the VX TLT index rose sharply as well in recent days however, the relationship between TLT Vic and VX TLT has, is dramatically different because now it is sharply negative in the minus 0.5 range as VX TLT has risen again, just like March of 2020, and TLTs price has fallen [unclear 10:28].
Patrick: Yeah, I think I'm with you. I want to bring in Litch here. What does this rise of the treasury yields mean for corporate bonds specifically?
David Litchfield: With corporate bonds, there are two components to the risk. There's the credit risk of the issuer that is if one lends money to a company, how likely is that company to get into trouble and miss a coupon payments or not be able to repay the loan at all? Then in addition to that, there's also the interest rate risk. So as rates rise, the interest one receives on a corporate bond is not as attractive as returns elsewhere, and any shift to the feds accommodating monetary policy and any subsequent rising of treasury yields means the corporate bond yields will also rise. That is that price will fall. So whilst the credit spreads might remain tight, essentially the interest rate components that might drive that sell off.
Patrick: Okay. As the EME, the resident EMEA guy here, is there a different dynamic with the European markets that investors should be aware of when they're looking into that?
David Litchfield: Yeah, I mean the European investors have been used to an extremely low yield environment of leis in doing most of the shorter end of the curves and negative even [unclear 11:46] one year that was above a thousand percent in the height of the kind of sovereign crisis even that's trading. So I don't think that's likely to change in the European environment anytime soon, given where GDP and the monetary policy is. But certainly lost the bulk of the mandates over here are in local currency you know, euros or Sterling predominantly as the hedging, those local liabilities, there's significant ownership of dollar debt. And that's either an explicit mandates or from kind of multi-asset accounts. And because of the dynamics that we're seeing playing out in that environment, in the treasuries, we're seeing a definite increase in demands for the futures, the corporate bond futures to act as protection against those moves.
Patrick: Interesting. So it really is mimicking a lot of what's going on here in the U S?
David Litchfield: Yeah, the European move on the local currency debt might be a little bit later in the day, but certainly the same leavers are in play in terms of inflation on the monetary policy angle.
Patrick: Okay, Dave, I want to bring it back to you here. You know, you talked a lot about the different strategies. Are there any other additional tools available to market participants that, where they can express their opinions or hedge their risk tied to the volatility of these interest rates? As you know, where the fed decision is mere hours away?
Dave Kovtun: You know of the ETF options Dennis mentioned TLT, it's probably the most popular and the purest play on longest term, longer-term interest rates. I thought he made a great point about the unique dynamics of stock and vol in TLT, how you can get that kind of price up, vol up movement or price down, vol up movement. So it's kind of a tailwind for long options, both ways. It's, you know, you don't always know what regime you're in, but I think that's really interested in how, because of TLTs kind of places a Haven asset, you can buy a call and the price can shoot higher and vol can actually go up on that move. There are also options on the shorter term treasuries, those are tickers such as IEF and S-H-Y, and more recently with the markets contemplated and rising inflation, we've gotten more calls on options on a tips ETFs, T-I-P is one of those.
And it's worth noting that bonds aren't the only asset class that care about interest rates, right? If you look at the recent performance of tech or at growth stocks generally these stocks were on fire, and then really only took a hit when the specter of rising rates kind of reared its head. You know one could imagine many investors this past month, or whether they're trading Tesla options or options on the NASDAQ 100 QQQ options are in effect. They're making these trades through the lens of trade, changes in interest rates.
Patrick: Yeah, that's a very good point. And I feel like that is very relevant to a retail investor because they can wrap their head around that a little bit more. Dennis, do you have anything you want to add?
Dennis O’callahan: Yeah, actually I, as I began to look at this, I looked at a tool that FT options that we, a company that we've recently bought because they have some analytics. I was looking at Vega traded in TLT options over the, in recent days as these inflation concerns have crept into the marketplace. On February 25th, I saw that we traded five point million Vega in TLT options. And of course Vega is the option price and set price sensitivity to volatility. And so this is telling us how much dollar value there would be in a 1% move in plight volatility. The Vega traded on February 25th was about four times the average Vega traded daily in all of, in 2021 so far. So, yeah, it's, these are exciting times. And that Vega has been showing up in other products as well. Not surprisingly for the VX TLT the, went up from 5.5 vol points to 26.5 on February 26. So their strong movement in these markets as a result of all these concerns, inflation concerns, is one of the primary ones clearly.
Patrick: Yeah, I mean those are staggering numbers to someone who, to the uninitiated. So we, one thing is clear we're at an inflection point here with longer-term treasury yields, inflation concerns increasing, corporate credit spreads are still near their lows. Let's go, Dave, Dennis, and then Litch can finish this. What does this inflection point reveal about investor sentiment?
Dave Kovtun: Clearly a lot of dynamics going on, a lot to unpack. Fundamentally much of it comes down to the market bracing for two things, you know, rising inflation and changes in interest rates. If you look at the data traditional measures of inflation have yet to really reflect any acceleration there, but clearly the market is viewing kind of this combination of an accommodative fed. At least they were, as of this recorded at noon here on Wednesday and broad fiscal stimulus, which we've seen those things together are inflationary in nature. And, you know, if you've got inflationary pressures, could you get into a situation where you get almost an overshoot of inflation, which in turn has to be met with faster than expected rate hikes. And that what you're seeing being priced into the yield curve recently. So then you ask, you know, how is that going to impact credit? You know, Litch talked about those two inputs that go into bond price in the rate component, you can think of as treasury yields.
And then the spread component a risk premium and that's really kind of the compensation that you get because, you know, the borrower might default, you might not get paid back, right? So from that perspective, the impact on different types of credit could be quite different specifically when you think about investment grade versus high yield. You know, in high yield, the overwhelming input and most of your compensation for taking the risk comes from that risk premium component that spread component. So interest rates, treasury rates can move, but overwhelmingly it, you know, how well you do on a high yield loan is essentially going to come down to, you know, the spread component. And the very things that are driving yields higher right now, this positive fundamental backdrop, you know, the vaccines that are being rolled out, the broad reopening at state levels, stimulus, you know this all boats quite well for economic growth and corporate earnings, you know, that, makes people feel pretty good about the spread component about being paid back.
So it's less clear like how this might impact things like the HYG things that you know, high yield, investment grade is a lot less clear because when you talk about investment grade, that rate component. The treasury commode is a much bigger proportion of kind of your total compensation and what, so when you're thinking about, you know, do I want to get involved in investment grade bonds you have to be much more kind of rate sensitive comparing the return you're going to get versus the risk-free investment.
And, you know, if people hear some bit from the fed on there today, or maybe at the June meeting that they don't like, they're probably going to think back to 2013, that was the taper tantrum where investment grade initially hung in there despite rising treasury yields. Only to see credit spreads in those investment grade bonds suddenly widen to the tune of about 35 basis points in two months that May and June.
That was a pretty severe move for investment grade, but you know, a lot of people in the market remember it like it was yesterday and definitely on people's minds. And then the other questions that kind of remain out there are, you know, how much longer, or how much further can treasury yields rise against a backdrop of both, you know, a zero fed funds rate and those low or negative yields globally that Litch touched on earlier when you think about kind of the relative return that you can earn here in the U S versus debt elsewhere, you know? Can you really justify treasury yields going much higher than they are now? And then, on the spread side can this very positive credit backdrop, you know, the vaccines, the stimulus, things like that, can they drive spreads much below their, pre COVID types you know?
And if so, how much farther can those spreads compress? Those are really the questions. And obviously kind of on the supply demand side, you know, issuers are realizing that the low rate environment won't be here forever, that leads to an increase in borrowing. There's almost a kind of like, if not now, it's not now or never kind of feeling, and on the hedging side, you know, you've got increased borrowing, that's more leverage in the system. That's clearly driven more hedging activity. People looking to use the fixed ETF options, you know, and unlike certain spread derivatives when you're holding cash bonds it's nice to have a product that is a basket of cash bonds. And that's exactly what ETFs are so, I think it's no coincidence we're already tracking for record volumes just based on the first two months in those fixed-income ETF options.
Patrick: Right, very well said, Dennis, you got anything to add?
Dennis O’callahan: Yeah, actually I was, one thing that we are looking at is the volatility across the term structure of treasuries is not uniform. Obviously inflation is going to have a bigger impact on longer dated treasuries. And so we're, you know, that's something that we've been kind of watching and solids, as Dave mentioned, its different types, but different tenders also have differentially affected by the current environment.
Patrick: And Litch, bring it to a close here.
David Litchfield: Yeah. For me, I think investors are really looking at that implied fed put, right? So Dave mentioned the environment and the tape attention. I think what's changed obviously in the last 12 months, 12 months and one day is the bond buying program that Dave spoke about. You know investors are sitting there thinking if there is a significant widening of the credit spread, then the fed is going to come in and start buying up corporate bonds even to the extent of high yield.
Patrick: Right.
David Litchfield: But then the fed has got to play off that policy action versus having to increase rates if inflation does get out of control. So there's those two dynamics that are probably going to start pulling against each other at some stage. And whilst I don't think the fed put has disappeared, I think it's more of a question where is that strike? Maybe the strike of output is actually a bit lower and there is scope for a bit more movement in those bond prices than perhaps there was six months ago. So for me, I think it's about that fed put and how badly that inflation pressure is going to cause the fed to become more hawkish in their policy. And as I said before, that's why we've seen a significant increase in demand for the futures to use as protection. So we have two, we've got the high yield futures and the investment grade futures. And Dave's point earlier about going short, buying ETFs can at times be a bit challenging, you know, putting together a synthetic short via long put, short call. The futures is a perfect instrument for that you just hit the bit and then sell futures. Yeah.
Patrick: Yeah, that's an excellent, excellent plug there at the end, Litch. I'll open it up then to Dave and Dennis; do you guys have anything you want to plug as we wrap up here?
Dave Kovtun: Sure. Just, yeah as I mentioned last time at Jane Street we are a global trade-in firm 1400 people strong across U S Europe and Asia. Our client business institutional client business spans fixed income to ETFs to listed options specifically recognized as one of the largest liquidity providers in these fixed income ETFs work we're chatting about today. We definitely take pride in our ability to make markets in all conditions across those asset classes. So, we'll see regardless of what the rest of 2021 has in store, we look forward to going wherever our clients need us.
Patrick: Nice, and Dennis bring us home.
Dennis O’callahan: In derivative strategy at CBO my area, we are watching fixed income markets really closely and are always thinking to build better tools for market participants. Stay tuned as we work to bring some of these new tools to market.
Patrick: Nice. You hear that everybody, stay tuned. So that's, I'm ready to wrap here, gentlemen Dave Kovtun of Jane street and then CBOE's Dennis O'Callahan and David Litchfield. Thank you guys for coming on. Yeah, I mean, like you said, we'll see probably calls for a follow-up episode in about six months, but thanks again for coming on and we'll talk to you guys soon.
Dave Kovtun: Thanks Patrick.
Patrick: Cheers, everybody.