Bunds Buffered From Treasury Tumult May Lose Seasonal Shelter

As benchmark U.S. Treasuries were caught in a maelstrom on Tuesday, one closely related asset held up much better: bunds.

While 10-year Treasury yields climbed more than seven basis points that day, the rate on comparable German notes rose just half as much. One likely reason bunds fared better was swap dealers, holding the equivalent of a short bond position, looking to hedge their book by buying government securities.

Here’s how they got their short positions:

Around 15 billion euros (almost $18 billion) of bonds from European financial issuers were priced through Monday and Tuesday alone. Companies issuing fixed-rate bonds typically hedge their exposure to better match their cash flows.

They do so by converting their fixed-rate obligation into floating-rate payments. A bond dealer agrees to the swap transaction and is left holding what is essentially equivalent to a short bond position. In turn, the dealer hedges his short position by going long the rates market, supporting German bunds and other debt securities (see graphic below).

January is traditionally when European issuers are more active, particularly financial names. For each of the last four years, the first full week saw the highest volume of the year, according to data compiled by Bloomberg. This year, however, much of the sales have come in the second week, owing to a holiday-shortened first week and the introduction of MiFID regulations.

The impact of this seasonal hedging flow can be observed in the market. In eight of the last 10 years, the spread between interest-rate swaps and German 10-year bond yields has tightened in the first two weeks of trading.

As these flows pass through the market, and seasonal issuance drops off, there may be scope for German yields to rise and the spread with Treasuries to tighten.

— With assistance by Hayley Warren

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