Special Report: The Growing Importance of Fixed-Income Futures

The use of futures contracts in fixed-income portfolios is becoming more and more prevalent, despite the derivative being around for some time. Increasing interest rates and deeper, more complex fixed-income markets have managers of different strategies optimizing their exposure and liquidity with futures. Here’s how:

• Active managers can use bond futures to hedge against interest rate or credit spread movements. They can also manage cash flows and maintain liquidity in their portfolio if they are exposed elsewhere.
• Managers can take long or short positions on specific bonds and hedge out the beta using futures.
• Fixed-income managers can use futures contracts to underweight or overweight certain positions.
• Pensions, insurance companies or other mandates restricted from using OTC instruments can use futures.
• Hedge funds, especially Commodity Trading Advisors (CTAs), can easily access corporate credit.

Deeper Dive

One industry where the flexible instrument has shown considerable value are pension funds and insurance. Pension funds and insurance companies have used derivatives in the form of Treasury futures for years; these instruments are used for duration management. The issue of cash management still exists, and these types of funds are typically prohibited from deploying OTC derivatives.

“While pension funds and insurance companies are used to using these Treasury futures to manage the duration, they have nothing really to manage the credit portion of their book. And that’s where these futures really hit a chord with those investors in terms of providing a very valuable instrument for them to use,” says David Litchfield, Director of Derivatives Sales at Cboe.

He adds, “In the current macro environment where interest rates play a greater part in impacting investment portfolios, our product references corporate credit – the actual bond themselves – and also includes an interest rate component. This helps companies and funds manage both their duration and spread risks,” a reference to the Cboe iBoxx iShares Corporate Bond Index Futures and Options on Futures.

Such specialized types of futures and options on futures offer capital-efficient ways to manage risk in both the high-yield and investment-grade corporate bond market and are helping to ease the limitations of certain investment strategies.

Many investors have recently begun looking to futures as alternatives or supplements to ETFs. ETFs are an efficient way to gain market exposure, but often come with wrapper constraints. These can include regulatory requirements like tracking a specific index or diversification limits. ETFs also often include limitations on the types of securities that can be held within the fund and the amount of leverage it can hold. There are also often restrictions on the use of derivatives and other financial instruments that can be held within the fund itself, which is what makes futures such a powerful tool.

For fixed-income managers specifically, futures are a significant complement. ETFs very much look and operate like an equity, but there are certain investment mandates that do not allow for the ownership of an ETF product. ETFs trade on the same exchange as cash equities, and the ETF wrapper itself can often look very much like an equity, and as such might be prohibited from fixed-income mandates.

“As another tool in the toolkit, the futures can sit alongside and alleviate some of the constraints that the ETF wrapper poses,” Litchfield adds.

Deeper Look

Futures serve as an addition to, but not a replacement for, other investment vehicles as a way to optimize returns and balance different positions — which is central to their power.

“l’m keen to point out is that it’s not necessarily a better or worse product,” Litchfield says. “It does something different.

“For example, if an investor is fully funded, they might like to have all their cash fully funded in the ETF wrapper, whereas the futures, explicit or otherwise, are a leveraged instrument. One puts down a small portion in the initial margin, and then one is left with a lot of other cash that one can put elsewhere. And if one doesn’t like that leverage, then that cash is typically parked in a money market fund,” Litchfield points out. “A fully funded investor can then determine what return they are getting on that cash compared to being fully funded in the ETF.”

Hedge funds and CTAs seek diverse avenues of access to financial markets to broaden their portfolios. One prominent method, particularly favored by CTAs, involves the use of futures contracts.

This unique subset of the hedge fund community, driven by distinct investment objectives, finds specific value in the exposure provided by futures. These instruments give CTAs exposure to various commodities, currencies, and financial instruments without the need to physically own the asset.

Deeper Look

CTAs represent a distinct category of investors poised to capitalize on these specialized tools. They occupy a strategic position, serving as the ideal beneficiaries of futures that unlock opportunities to an entirely new market.

“A specific subset of the community that is very interested in the futures is the CTA community and managed futures accounts. They trade interest rate futures and government bond futures, equities, commodities, and the big part of global macro strategies that they’ve been shut out of thus far is the corporate credit market. Lo and behold, here is now a future that can fit into their systematic trading program where they haven’t been able to access it before,” Litchfield says.

“In all of my conversations, as excited as various potential users are — be it sovereign wealth funds, the asset owners, asset managers, CTAs, hedge funds, whomever they are — there’s only one question that they ever ask, and it’s the only thing they care about: liquidity,” Litchfield says.

Managers across the investment spectrum can enter and exit positions rather quickly without impacting the market price. Additionally, managers can opt to keep cash on hand while using a smaller portion on margin to gain quick exposure, versus owning the entire underlying asset outright.

So how is the future liquid?

Deeper Look

Corporate bond futures now trade on an index, and a new market and access to liquidity has evolved as a result.

“Our iBoxx futures suite is a part of the liquid S&P Dow Jones Indices fixed income tradable ecosystem, ” Litchfield says, referencing Cboe’s collaboration with S&P DJI and the licensing of its iBoxx high yield and investment grade bond indices as the underlying benchmarks for these futures, and options on futures products “That’s where we, S&P DJI and BlackRock have come together and said if we tied it explicitly to the ETFs — the ETFs trade $2-$3 billion a day on exchange with very tight bid/ask spreads — then the liquidity of those two markets can coexist and complement each other….so as someone’s buying futures, the market makers and liquidity providers behind the scenes are hedging themselves by buying ETFs,” Litchfield explains. “If the ETFs trade $3 billion a day, the futures have a large liquidity pool to tap into, and that to me is one of the biggest considerations for portfolio managers, traders and potential users out there: how liquid these things are.”

These new and adaptive futures are rapidly becoming an efficient new instrument in a manager’s toolkit. Complementing a wide array of needs, just some of their features include alleviating ETF wrapper constraints, giving corporate credit access to those who did not have it before, and providing liquidity to funds or companies in new ways.

“The only thing that portfolio managers and traders really care about at the end of the day is liquidity, and that’s where I’m confident that we’ve solved that problem in the product that we have,” Litchfield says. “Part of the reason it’s never been done before is that fundamentally trading two and a half thousand investment grade bonds at the click of the button is impossible.”

Now you can write a future on that.

To learn more about Cboe iBoxx Corporate Bond futures visit cboe.com/iboxx or contact David Litchfield at dlitchfield@cboe.com.