Financial-market volatility has awakened from its doldrums.
It only took the Federal Reserve considering reducing its balance sheet, geopolitical tensions flaring in North Korea and Syria, and a new contender emerging in the French presidential election to make it happen.
Some of the world’s biggest bond managers have been waiting for this moment. Rather than ponder the sustainability of the reflation trade and its implication for yields, investors including Rick Rieder at BlackRock Inc. and Bob Michele at J.P. Morgan Asset Management say they’ve been betting that price swings will grow more dramatic in the days and months ahead. That’s already borne fruit this week, with the CBOE/CBOT index of 10-year Treasury note volatility, known by its ticker TYVIX, jumping to the highest closing level since February.
“I am a buyer of vol because we are finally getting to a period where the Fed will begin to reduce its balance-sheet size and you’re going to see the same out of the ECB” after the German elections, said Michele, J.P. Morgan Asset Management’s chief investment officer of global fixed income, currency and commodities. The firm oversees about US$1.7 trillion. “It has been the central bank balance sheets which are the biggest distortions of bond markets.”
The violent price swings throw a wrench into wagers that volatility would remain subdued, with US equity indexes hovering near all-time highs and Treasury yields stuck in a tight range. In both bond and stock markets, fund managers had been shorting volatility to generate additional yield, such as by selling out-of-the-money put and call options.
Bond-market veteran Bill Gross at Janus Capital Group Inc. suggested such a strategy for his US$2 billion Janus Global Unconstrained Bond Fund in December after the Fed raised interest rates. Gross didn’t respond to a request for comment on his latest volatility positioning.
Michele said he’s going long volatility by improving portfolio convexity and reducing the fund’s agency pass-through positions.
Another route to profit off volatility is through swaptions, which provide a hedge on interest-rate risk. A payer swaption grants the right to pay a fixed-rate on a swap contract. Payer swaptions increase in value as rates rise.
Normalized volatility on three-month options for 10-year US interest-rate swaps, known as 3m10y swaptions, climbed this week to the highest level since the Fed’s interest-rate hike last month. Similarly, 3m30y swaption volatility is at a one-month high, though it remains near the lowest since 2014.
BlackRock is going long volatility more than it’s shorting it in the US$27.8 billion BlackRock Strategic Income Opportunities Portfolio, according to Rieder, who co-manages the fund as the firm’s chief investment officer of global fixed-income.
The Merrill Option Volatility Estimate, or MOVE Index, measures swings based on one-month options for two to 30-year Treasuries and last month reached the lowest since before the Nov. 8 US elections. It has since rebounded to about its one-year average.
These latest moves don’t necessarily mean volatility sellers will be squeezed out of the market. For equity-fund managers, one strategy for selling volatility that’s growing in popularity isn’t as much about betting on the direction of the market as much as it is about generating income, according to Pravit Chintawongvanich, head of derivatives strategy of Macro Risk Advisors.
And since they’re not necessarily betting on the direction of the CBOE Volatility Index, known as the VIX, they aren’t required to cover their position if volatility spikes, and may choose to continue selling the options. While sellers of volatility typically actively hedge their position with stocks, the income-driven strategy has grown among pension funds and traditional asset managers, according to Chintawongvanich.
“They harness volatility in a different way,” he said by phone. “I think the reason is because yields are super low and people have been saying for years equities are fully valued. So if you believe that, you’re not giving away too much upside.”
Still, Chintawongvanich understands the appeal of betting on rising volatility. After all, there’s still the chance that anti-euro candidate Marine Le Pen wins the French presidential election, and the emergence of Jean-Luc Melenchon as a fourth viable candidate could alter the race. That’s on top of geopolitical tension between the US and North Korea, Russia and Syria.
“Vol has been bid over the past couple of days because of the French election -- the US was not pricing in any event premium,” Chintawongvanich said. “It’s an event that most likely will end up being fine, but there’s a very small risk of a very bad outcome.”
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Copyright Bloomberg 2017
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