Bund Call Skew Steepens on Brexit, Bond-Scarcity Risks: Analysis

The steepening of bund volatility skew in favor of calls reflects rising Brexit risk premiums and investors positioning for increased bond scarcity, Bloomberg strategist Tanvir Sandhu writes.

U.S. Treasuries, bunds and U.K. gilts remain well-supported into Britain’s June 23 vote on its European-Union membership as “leave” poll gyrations increase and downside risks are far too large on being wrong.

Negative convexity dynamics is taking hold in the bund market, where the pool of bonds Bundesbank can buy is shrinking and increased purchases of what remains amplifies a bullish flattening of the yield curve.

Euro swap spreads are set to extend their widening trend as bund scarcity concerns are most directly expressed in asset swaps. As pension funds’ funding ratios deteriorate, receiving interest at the long end of the swap curve is most likely to increase.

As returns get squeezed out of the curves, pension funds and insurers with large liabilities are being forced to increase their DV01 further out the curve. Widening duration gap between liabilities and assets amid falling yields spurs demand for duration for asset-liability matching.

Yields on German bonds maturing up to and including January 2022 are now below the European Central Bank’s deposit rate of negative 40 basis points, making them ineligible for purchases. With ECB running out of German paper, they will either have to cut the deposit rate or adjust issue-limit restrictions.

German bond supply is set to turn strongly net negative (adjusted for QE) over summer, which will further weigh on yields. The average maturity of assets purchased under QE has been increasing, adding support to long-dated paper.

Downside options may come into play where a vote to “remain”, in line with betting odds, will see an unwind of Brexit premiums in bunds and renewed Fed hawkishness weighing on global bonds.

The bund futures contract may ultimately approach the roll gap at about 166 and then approximately 168, corresponding to a yield of approximately negative 20 basis points as inflation forwards show achieving ECB’s target is a long way away, keeping distribution of expected outcomes in a narrow range.

Comparison of July skew today vs 5 days ago:

25d skew at 0.57 vs -0.23
15d skew at 0.93 vs -0.31
10d skew at 1.22 vs -0.33

Note: Tanvir Sandhu is an interest-rate and derivatives strategist who writes for First Word. The observations he makes are his own and are not intended as investment advice.