Finding Value in VolatilityFindingValueinVolatility

As 2021 came to a close, the US Treasury market experienced a particularly volatile period, especially relative to the broader stability of the credit markets. Policy-sensitive rates across developed markets rapidly repriced at the end of October amid relentless inflation pressure, causing broad shifts in market positioning. Concerns about new variants of COVID-19 similarly whipsawed the markets late in the year.

The magnitude of the Treasury market volatility was historically significant, and the breakdown in the price relationship of normally highly correlated bonds drove dislocations in fixed-income relative value to extremes witnessed only during acute systemic crises, such as the Global Financial Crisis of 2008 and the early days of the pandemic.

The forced unwinds of leveraged investors has created unprecedented dislocations in various parts of the Treasury market and resulted in attractive relative-value opportunities, including in 10- and 20-year bonds.

The richening of (very) old 10-year bonds

The US Treasury regularly issues new government bonds monthly or quarterly, depending on the maturity. In normal market conditions, investors have a defined preference for the most recently issued bonds, known as on-the-run securities. The premium investors are willing to pay for such securities relative to other bonds of similar maturity is known as the “liquidity premium.” One way to measure the liquidity premium is to calculate the spread of the on-the-run security against an interest rate derivative and compare that to those of similar securities.

Since on-the-run bonds tend to be more liquid and offer lower transaction costs, the liquidity premium normally rises and asset swap spreads widen during periods of stress. For example, in March 2020, the asset-swap spread between old off-the-run 10-year Treasuries issued in 2019 and on-the-run seven-year notes rapidly widened, creating a 5+sigma event.

In late 2021, we witnessed an unprecedented counter-reaction. Forced unwinds of leveraged positions drove the asset swap spread to quickly compress, leading to a significant richening of off-the-run securities. We believe many macro funds were forced to purchase these eight-year notes — which were already trading rich — in order to cover short steepener positions, contributing to the relative-value anomaly in this localized segment of the curve. The extreme liquidity premium quickly reverted in March 2020, and we believe mean reversion will again prevail as the value of the off-the-run notes cheapens over time.

The cheapening of 20-year bonds

Cross currents at the long end of the Treasury curve also created sizable relative-value opportunities. Since its re-introduction in May 2020, the 20-year bond has traded poorly relative to similar maturities. One way to gauge the relative undervaluation of the 20-year bond is to compare it with Treasury futures of similar maturity. Recent disruptions in the market and large liquidations of the 20-year sector have further amplified the relative cheapness in the bond, creating a 4.4 standard-deviation move in late October. The U.S. government is acutely aware of the relative cheapness of the 20-year bond and has recently taken several steps to alleviate the supply-demand imbalance.

In 2020, to fund COVID-related fiscal stimulus, Treasury rapidly increased bond issuance and disproportionately increased supply in the 7- and 20-year sectors. The overwhelming supply outstripped demand and has led to the relative cheapness exhibited in those two securities since. The recent, rapid economic recovery alleviated Treasury’s need to issue as much debt. Consequently, Treasury officials cut issuance across all maturities and disproportionately reduced supply in the 7- and 20-year sectors (see chart), and further signaled the potential for more reductions in the upcoming quarters.