Widespread expectation of U.S. rate hikes is creating novel short-term derivatives trading opportunities. Keith Styrcula, chairman at the Structured Products Association in New York, said arbitrage opportunities have emerged between municipal bonds and Treasuries over the past few weeks while foreign exchange and commodity-linked structures have also seen a surge in interest. Market participants are predicting the Federal Reserve will raise interest-rates in the summer.
An anticipated interest rate hike has dampened demand for municipal bonds and when demand for munis is weak there are often attractive relative value opportunities between munis and taxable bonds, explained Yingchen Li, director at Merrill Lynch in New York. Demand for munis is hit hard when rates are rising because retail investors account for a large slice of muni investors and these players typically move into other products, such as interest bearing accounts, in a rising rate environment. Issuance of muni bonds is expected to lessen over the summer, which is the end of the muni calendar year and this will redress the supply and demand equation and in turn strengthen muni performance, he predicted.
To take advantage of the temporary muni weakness, so-called MOB (municipals over bonds) spread trades are popular, according to Styrcula. These comprise taking a long position in muni futures and a short position in Treasury futures and take advantage of the price difference between the two. The structures, which typically have maturities between one and three months, are often hedged with total return swaps, he added.
Similarly, volatility in the foreign exchange market, which has been created by the anticipated rate hike, is also promoting increased interest in structured fx deposits. Jim Kamphoefner, principal in fx structuring at Bank of America in San Francisco, noted that recent high levels of volatility have increased the premium earned from selling options embedded in many structures.
Low interest rates have prompted investors to buy more non-vanilla structures that can offer relatively high returns, added Eric Ohayon, head of fx structuring at BofA in London. With low rates, vanilla notes on the U.S. dollar would return only around 1%, whereas by taking a view on a currency pair investors can pick up a higher coupon, for example between 4-8% per annum, he noted.
