BofA Sees Ultra-Long Gilt Future Demand Over Time: U.K. Credit

Analysts are cautioning against a rush to judgment as ultra-long U.K. government bond futures begin their first week of trading.

Demand from pension funds seeking to hedge their liabilities and pressure from regulators to switch to exchange-traded derivatives will help to support the NYSE Liffe 30-year gilt future, according to John Wraith, a fixed-income strategist at Bank of America Merrill Lynch. Market volumes in the contract today were half the average in the first three days.

“The ultra-long future is a useful instrument and it has a lot going for it,” London-based Wraith said in an interview. “The U.K. has a pension industry big enough to make the new product viable. It may have had a cautious start, but that’s inevitable for a new contract. It’s a crucial process to build enough liquidity to attract investors. That takes time.”

Futures contracts allow investors to bet on the value of a cash security at a fixed point in time. On expiry, the underlying asset is delivered. Traders use the securities to hedge positions taken in the gilt market. For pension funds, ultra-long futures contracts provide an alternative to holding cash gilts.

The 30-year future expiring in June had an average daily volume of 2,339 contracts in its first three days, data compiled by Bloomberg show. About 1,092 contracts were traded as of 5:15 p.m. today. The so-called front contract for the 10-year future has seen average daily volume of about 161,000 this year.

‘More Transparent’

The ultra-long contract is based on cash gilts maturing in 28 years to 37 years. Barclays Plc, Lloyds Banking Group Plc, Morgan Stanley, Royal Bank of Scotland Group Plc and UBS AG are designated market makers that provide two-way quotes, NYSE Liffe said in a statement received March 28. The contract was introduced after a four-month delay to allow time for customer testing and preparation.

The future due in June 2014 rose 0.2 percent to 108.32 today. The 10-year gilt future maturing the same month was up 0.2 percent at 109.38, with 112,455 contracts traded.

“We have seen a solid start for both trading and open interest in ULGs in the first three days,” Adaora Anunoby, a spokeswoman for NYSE Liffe, said yesterday in an e-mailed response to questions. “Relative to the U.S. and Europe, U.K. debt tends to be longer dated and the 30-year part of the U.K. sovereign-cash curve has strong fundamental liquidity.”

Hedging Tool

Some investors use interest-rate swaps to hedge their interest-rate risks. With regulators increasingly demanding central-clearing of derivatives to boost transparency, ultra-long futures offer an alternative way to protect against those risks, said Anthony O’Brien, a fixed-income strategist at Morgan Stanley.

“Futures contracts are simple to understand and ultimately are more transparent,” O’Brien said in a phone interview. “Regulators are happy to see these contracts spring up. Pension funds who have asset-liability mismatches, and many of them do, can use this ultra-long futures contract instead of swaps to address the problem.”

NYSE Liffe already offered short-term contracts covering gilts with maturities between 1 1/2 years and 3 1/4 years. They also offered long-gilt futures based on bonds maturing in 8 3/4 years and 13 years. When that contract was introduced in October 1982, average daily trading volume for the month was just 1,289. Medium-term futures are for gilts due in 4 years and 6 1/4 years.

Most Liquid

While short-term gilt contracts have to compete with the bigger and more liquid short-sterling market, the ultra-long product doesn’t face the same challenge, said O’Brien.

The most liquid bond futures are in the 10-year area. In Germany, volumes in 30-year futures were about 2 percent of the 10-year contracts traded last year, according to data compiled by Bloomberg. In the U.S., longer-term futures represent about 6 percent of the 10-year contracts traded.

“What we see in Germany or the U.S. suggests that the ultra-long gilt future doesn’t have to be as liquid as the long gilt market to function well,” said Peter Osler, head of rates strategy at Marex Spectron Group Ltd. in London. “The product has a use, but investors need to be confident before they use them. They must be able to get in and out of the market without any difficulty. Liquidity begets liquidity.”

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