Short-Bond Shortage Isn't Over
Imbalance in 10-Year Treasurys
May Have Cost Investors Millions;
September Futures Contract Looms
By MARK WHITEHOUSE, AARON LUCCHETTI and PETER A. MCKAY
Staff Reporters of THE WALL STREET JOURNAL
August 11, 2005; Page C1
The imbalance in the Treasury market that cost some
investors hundreds of millions of dollars in June could rear
up again in September, but increased scrutiny of potential
market manipulation likely will mitigate the problem.
At issue is the trading of government bonds and futures
contracts -- promises to deliver bonds at a future date. The problem: Futures
contracts far outnumber bonds readily available to fulfill them.
The June losses began after one of the world's largest bond-fund managers,
Pacific Investment Management Co., had amassed billions of dollars of the 10year Treasury futures contract due for delivery that month, and other investors
feared the Newport Beach, Calif., outfit would demand the bonds.
That caused a rush on those bonds. And there weren't enough available to fulfill
the demand, leading some to believe that owners of those bonds were
purposefully hoarding them to drive up the price. To address the problem, the
Chicago Board of Trade imposed a new rule limiting how many bonds any one
futures holder could demand be delivered, but that had the unintended
consequence of driving down the price of some futures contracts, causing more
losses.
The Treasury said this week that it is looking into the matter and is considering a
way to make more bonds available to prevent future shortages. A CBOT
spokeswoman declined to comment. Pimco says it didn't intend to cause any
harm.
The futures contracts come due each quarter, so there is a chance the problem
could resurface in late September. But experts say the June experience has
made the market and regulators wiser.
"I think the amount of market and regulatory scrutiny would deter any predatory
activity," says Jason Evans, head of Treasury trading at Deutsche Bank
Securities in New York.
The trouble started in the market for futures, which investors of many stripes
traditionally use to hedge their bets in the bond market. An investor in corporate
bonds, for example, might sell a Treasury future to protect himself against an
unexpected rise in inflation that could harm the price of the corporate bond. A
bond fund might buy futures instead of actual bonds if it feels the futures are a
better deal.
Futures investors usually demand delivery on less than 10% of all contracts -they don't want to actually take possession of the underlying bond. More often,
they trade their old contracts, which come due at the end of each quarter, for
new ones.
Lately, the market for futures on 10-year Treasury notes has faced an increasing
imbalance. The dollar volume of contracts has boomed, exceeding $200 billion
as of Aug. 2, compared with about $62 billion five years earlier. Meanwhile, the
amount of bonds available to deliver against those contracts has decreased, in
part because the Treasury has been issuing shorter-dated bonds to finance U.S.
budget deficits and also because more foreign investors are buying the bonds
and tend to hold them for long periods.
Futures contracts specify a number of different bond issues that are acceptable
for delivery, but problems can arise when one of the deliverable bonds is a lot
cheaper than the others -- and the people who must deliver face a battle to get
those scarce "cheapest-to-deliver" bonds. Certainly, some people are winners in
this scenario -- those holding the cheapest-to-deliver bonds as demand pushes
up the price.
The result is a "lot more clamoring" for bonds that are needed to close out 10year futures contracts, says James Bianco, head of bond-research firm Bianco
Research. "It's a technical problem that's growing, and it's not going to get
better."
The matter came to a head in June, when market participants noticed a serious
mismatch: Only about $10 billion to $13 billion of cheapest-to-deliver, 10-year
Treasury notes were available for the September futures contract, on which the
total value of bets was as much as $170 billion. That caused the price of the
September contract to rise sharply, as market players bet those on the wrong
side of the futures trade would have to deliver more-expensive bonds.
As it happened, Pimco had bought a lot of June 10-year futures -- one trader said
as much as $14 billion, though the firm hasn't named any numbers. Typically, the
fund's managers would simply trade those contracts for September contracts, but
because the price of the September contracts had risen so much, the trade
became prohibitively expensive. As Bill Gross, Pimco's chief investment officer,
said in an interview Tuesday with Bloomberg Television, that "was the original
problem in this whole process." Mr. Gross didn't return calls seeking elaboration.
When Pimco decided to keep its June contracts, the market took that as a signal
the firm would demand delivery. It isn't known how many bonds Pimco actually
received, but the perceived demand for the cheapest-to-deliver bond for the June
contract -- a 10-year Treasury maturing in 2012 -- turned into real demand as
investors scrambled to get the bond. Adding to the urgency: The next cheapestto-deliver bond was about a full percentage point more expensive than the
February 2012 one, and the CBOT levies a fine of 1% of a contract's value on
anyone who fails to deliver a bond.
The demand exacerbated problems in a related market. Investors also lend
bonds to each other in return for short-term loans that they use to make other
bets -- the so-called repurchase, or repo, market. That market was already facing
a shortage of the February 2012 notes -- a situation known as a squeeze.
Some investors in the repo market bet that a bond will fall in price by borrowing it
and selling it, in the hope of repaying the loan with a bond purchased later at a
lower price. If those investors can't return the borrowed bond, a "fail" occurs. In
such cases, the borrower has to keep paying the interest on the bond to the
lender.
When the demand from the futures market kicked in, the fails worsened. In the
week ending June 15, a daily average of about $74 billion of Treasury
transactions failed, compared with only $8 billion in daily fails a month before.
The inaccessibility of the cheapest-to-deliver bond caused the price of the June
futures contract to rise, because the market expected more-expensive bonds to
be delivered. This created an unusual opportunity for anyone who was holding
the cheapest-to-deliver bond to make money by selling them at the higher futures
price.
If any investor who owned the bonds withheld them with the specific intent of
manipulating the futures market, that could be illegal under rules of the
Commodity Futures Trading Commission, the federal regulator for the futures
market. But that is a high legal standard that has proved difficult for the CFTC to
meet in previous cases. A CFTC representative declined to say whether the
commission was investigating the matter.
June 29, in an effort to avoid a repeat of what occurred in June, the CBOT issued
a new rule saying no single entity could demand delivery of bonds on more than
a limited number of contracts -- 50,000 in the case of the 10-year Treasury note.
The new rule doesn't take effect until December, but it caused the price of the
September futures contract to fall, because it cut the demand for bonds that
could be delivered. That caught many futures players by surprise and led to big
losses on the September contract.
"It caused major pain to Wall Street and to hedge funds," says Chas Mancuso, a
futures broker at Fimat USA LLC, a unit of French bank Société Générale SA. He
estimates the losses might have reached $500 million. The Futures Industry
Association, a trade group, issued a letter to the CBOT
severely criticizing the rule change.
Treasurys
Treasurys ended slightly lower after a disappointing $13
billion sale of five-year notes spurred fear that foreign
investors are losing interest in U.S. government securities.
The bid-to-cover ratio, a general measure of demand, stood
at 2.92, up from the 2.46 average of the past 10 auctions of
five-year notes. But indirect bids -- those from foreign official
accounts and others that don't bid directly through the
Treasury -- represented only 22% of the $12.8 billion in total
competitive bids accepted. That was well below the 30% in
July's five-year sale and the 39% average in such auctions in
the first seven months of the year.
Monday, a Treasury three-year note sale also saw much lower indirect
participation than dealers had hoped. Pending release of government-auction
data next month, it won't be clear how much less foreign institutions bought. Still,
the latest auction results "give us the sense that foreigners are taking a pause,"
said Ralph Axel, fixed-income strategist at HSBC in New York.
At 4 p.m., the benchmark 10-year note was down 2/32 point, or 62.5 cents per
$1,000 face value, at 97 27/32. Its yield rose to 4.398% from 4.392% Tuesday,
as yields move inversely to prices. The 30-year bond also was down 2/32 point,
at 111 29/32 to yield 4.580%, up from 4.576%.
--Shayna Stoyko contributed to this article.
Write to Mark Whitehouse at mark.whitehouse@wsj.com, Aaron Lucchetti at
aaron.lucchetti@wsj.com and Peter A. McKay at peter.mckay@wsj.com