Cboe’s new options add diversity and liquidity to the credit market

Cboe has recently launched two options on futures products to help investors manage exposure and mitigate risk in corporate bond portfolios: options on iBoxx high-yield corporate bond index futures (IBYO), and options on iBoxx investment-grade corporate bond index futures (IBGO). David Litchfield, director, derivatives sales at Cboe Global Markets, discusses the new and improved iBoxx offerings, the key challenges for firms and how they are using these products

What is new about these products and developments, and what is driving interest in them?

iBoxx high-yield corporate bond index futures (IBHY) and iBoxx investment-grade corporate bond index futures (IBIG) themselves are quite ground-breaking, in so much as they are the first listed derivatives in the space. It is significant that they are exchange-listed because there is a regulatory drive away from over-the-counter (OTC) instruments. In addition, many firms, such as pensions and insurance companies – not only asset owners – have mandate restrictions on the use of OTC derivatives. Many of these firms have trillions of dollars of corporate bond risk. They might be able to hedge the duration using Treasury futures, but most do not have the instruments available to them to manage the credit risk. They are typically not allowed to use exchange-traded funds (ETFs) either and are unlikely to have the mechanisms set up to allow them to short-sell an ETF anyway. So, having a listed future that is cleared is an ideal solution as a wrapper for them.

Many asset managers use OTC instruments, but there are differences between OTC derivatives and IBHY and IBIG. For example, in a credit default swaps (CDS) index, investors are only really protecting against credit spread. In this interest rate environment, asset managers want to capture the duration as well. So that is creating demand for these products.

In that space, the options on these futures are a brand-new instrument. Mandate restrictions apply to options on ETFs. Furthermore, the limitations in ETF options markets pose a big problem to investors. Eighty-five per cent of all the open interest in those options markets is in the front two months, because of the problems with pricing longer-dated optionality. In addition, the risk of being exercised early on those positions is significant. Our futures indexes are total return, so the options on our futures mitigate the early exercise risk while allowing asset managers to price longer-dated optionality.
 

What are some of the parallels in the equity investing space?

The equity space has a very developed listed market with every kind of derivative possible, be it in the OTC or listed space. And, for a long time now, there have been instruments available to protect equities during market events. For example, a portfolio manager can sell some S&P 500 (SPX) futures to protect a basket of US single-name equities, or buy an SPX put or a put spread, or sell a call.

I see the credit community using the equivalent tools in the credit space now they are available. So portfolio managers can now buy a put on credit to protect their credit portfolios going into certain events or enhance their portfolio yields by selling some call options.
 

How are the high interest rate environment and events such as the collapse of Silicon Valley Bank (SVB) affecting the use of these products?

This new market environment has piqued interest in IBHY and IBIG, and the options listed respectively on these futures – IBYO and IBGO.

This is similar to what we saw at Cboe during the Covid-19 pandemic or even with the Cboe Volatility Index, which was brought into focus during the volatility of the global financial crisis. Those events showed that the tools portfolio managers and investors were using might not be exactly what was needed and that something supplemental might be useful going forward.

In the same way, this new market environment has given life to Cboe’s corporate bond futures. When interest rates were low and there was no real movement in them, the duration on portfolios was not a big concern. Portfolio managers were only really concerned about credit spreads, and those that were able to could use OTC instruments such as CDS indexes to manage those. Those without the mandate to use OTC instruments were not necessarily troubled by that hedging activity and, if they wanted to hedge their duration, they could use US Treasury futures.

As interest rates increased, managers hedging cash bonds portfolios with a credit derivative found the credit spreads stayed very tight. Their bond portfolios fell in value because of the duration risk rather than the credit risk, and the hedge did not pay out because, fundamentally, it was the wrong hedge.

Cboe’s corporate bond futures offer something different. Hedging a credit portfolio of individual corporate bonds with futures that evoke an index of corporate bonds is a far cleaner and easier hedge than credit derivatives. And many of our clients only want to manage the credit spread, separate from the duration spread, and they are happy to use the CDS indexes in combination with Treasuries. So there are different ways of doing it. But where mandate restrictions are concerned, these are a different tool, which also offers cleanliness.

The collapse of SVB showed that, when markets are volatile, the immediacy of listed contracts is significant. When there is an order book with notionals ticking away – people buying and people selling – and prices moving quickly, traders want to avoid phone calls to OTC counterparties to negotiate different prices.

Cboe’s introduction of the new options on these corporate bond futures would have allowed people to put on protection strategies with more immediacy than they might have been able to, given mandate restrictions. These options are therefore a very significant development for any market structure. They bring different use cases and different liquidity profiles to the market. For example, the credit market is typically dominated by those using credit for credit purposes. Whereas, in the equity markets, there are volatility traders, who are not really concerned about the SPX and all the weights and components of shares – they just want to follow trends.

Offering these equity-like instruments in the credit space brings in more of those sorts of investors and better liquidity profiles. The obvious use case is the commodity trading adviser (CTA) community, which uses managed futures accounts to trend foreign exchange with commodities, interest rate futures, equity futures, and so on. For the first time, these futures allow them to access corporate credit, which is a big part of the global macro market.

Traditionally, credit-centric users all sold credit during the pandemic, creating a one-sided market against liquidity providers. The use of these options by the CTA community adds diversity and liquidity to the credit market, and it is exciting to see how this is transforming it.
 

What are some of the use cases you are seeing and what are some of the challenges firms are facing?

These options are very new products – only a matter of months old – and the futures are still very new in the larger context. So firms are figuring out how to implement the mechanisms to be able to use them. And, with any new product launch, it takes time to build trading volumes and liquidity, which can be a bit of a hurdle for institutional asset owners, for example, in getting the buy-in from risk committees. This is the classic chicken-and-egg scenario that any new product faces. However, more and more firms are using these products, and we expect the liquidity pool and difference of profiles to increase significantly over time.
 

What are some of the strategies firms might be using these products for?

In derivatives, firms use these products for all the typical reasons. First, they want exposure. It does not necessarily have to be leveraged, but leverage is available. Just like other derivatives, these products can be used to deleverage the portfolio, not just to increase the risk. And many institutional investors already use these products for protection.

Additionally, as I mentioned, the CTA community and transient players are taking advantage of price differences between the ETF, futures and CDS markets. These markets sometimes offer arbitrage opportunities, depending on their price movements at any given time. These are the kind of use cases we are seeing, similar to those you might see in the equity market.
 

What future developments do you expect around these futures, and options on futures?

There are still a few hurdles to launching these products, but we are at a stage where we can consider launching other exposures – expanding the product set from dollar high-yield and dollar investment-grade.

Cboe’s main aim is to expand the user base and increase trading volumes for the existing products we have listed. To this end, we plan to extend the maturities of the products we have. The longest-dated option on futures we currently have listed is the March 2024 contract. Soon, users will be able to trade options and futures with a maturity date of December 2024, providing more than a year of coverage. This will benefit different users with more fundamental or longer-term hedging strategies. This includes volatility players trading longer or shorter parts of the curve. Additionally, those utilising the total return stock market for funding and financing can benefit from pricing in borrowing costs by trading futures. As market funding fluctuates, long investors can find attractive opportunities by providing funding and buying futures at favourable rates, especially when locking in this advantage for a year.

On the hedging side, locking in favourable funding for a year becomes very appealing. The expansion of this futures market could attract more opportunistic traders, potentially extending the futures curve beyond March 2024. Different players will enter the market at various points on this curve, depending on their specific needs. At Cboe, we are eagerly awaiting this development as we can see there is strong demand.

Recently, due to strong investor demand, we extended global trading hours for these IBHY and IBIG to nearly around the clock: 23 hours per weekday (Monday through Friday). Many European traders used to wait for the US market to open before trading. This is common in equity markets, but not always practical. Sometimes, traders want to act during European hours due to immediate data releases or market events before the US market opens. While larger trades might wait for US markets to open, smaller rebalances that do not have any impact on liquidity or pricing benefit from immediate execution.

Now, with futures trading around the clock, portfolio managers can make these adjustments during European hours. We are also working to enhance liquidity during Asian hours, while the futures are open. Pricing corporate credits in dollars is feasible during European hours, and we aim to extend this capability into Asian hours as well. This way, customers can trade at their preferred times instead of leaving orders for banks to execute later. This is another exciting development we are eager to introduce to the market.

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