TMX POV - How the 30-Year Bond Futures Contract Completes the Canadian Yield Curve Puzzle

Global capital markets have seen frequent periods of volatility in the last two years. With the onset of the pandemic, investors divested risk assets while rallying behind government bonds. Bonds have traditionally been attractive to international investors seeking an efficient outcome, offering the best balance between risk and reward in the midst of market uncertainty.

The majority of the Canadian debt securities supply comes from government, municipal, provincial and federal bonds. From a global perspective, Canadian bonds represent about 3% to 4% of the MSCI All Country World Index and overall interest rate levels have remained relatively higher than those of the UK, Eurozone or Japan.

All these factors combined provide investors diversification options, the ability to boost portfolio performance in all market conditions and achieve better risk-adjusted returns. But to become a truly international marketplace and attract investment capital, the Canadian yield curve needed to be more robust, particularly in the long end of the curve. Pension funds and institutional investors with an average portfolio duration period of about 7 years, are looking to match long-term liabilities with assets outside of a 10-year period.

Building the Canadian Listed Yield Curve

Over the last several years, Montréal Exchange (MX) has been actively working to offer investors greater opportunities to trade along the Canadian listed yield curve. For the longest time, investors could either trade the Three-Month Canadian Bankers' Acceptance (BAX) at the front-end or the flagship Ten-Year Government of Canada (CGB) bond futures.

This left a huge gap in the yield curve and affected the ability to attract more capital from international investors and therefore boost liquidity. In response to rising demand from market participants, MX innovated its product suite to add the Five-Year Government of Canada (CGF) and the Two-Year Government of Canada (CGZ) bond futures contracts.

Historically, there has been a lack of supply in the long-end of the yield curve, particularly at the 30-year point where most pension funds and long-term investors trade positions. This is why the Canadian yield curve has been relatively flatter than other G7 countries. However, that barrier was lifted during the pandemic by the Bank of Canada's (BoC) bond issuance program. According to the BoC's annual report, the nominal value of marketable bonds issued in 2020 alone was $323.6 billion.

The time was right for MX to complete the last piece of the Canadian listed yield curve puzzle with the addition of a synthetic Thirty-Year Government of Canada bond futures contract (LGB). The launch of this product, made possible through a new market making program with two of Canada's leading fixed income houses, will boost liquidity at the long end of the yield curve as well as create a competitive long bond market in Canada that does not exist today.

Adding Liquidity to the Long End

The ability to acquire assets that match liabilities beyond the 10-year duration is critical to the success of pension funds and other institutional investors, and for positioning Canada as an attractive capital markets destination for global investors. MX recognized the importance of providing a synthetic option for portfolio managers to try to hedge that risk through the availability of a 30-year bond futures contract.

With bond futures contracts, investors can more easily execute relative value trades against other major markets, manage risk and duration of portfolios, and hedge cash positions for existing Government of Canada holdings by either keeping or creating synthetic long or synthetic short positions. The increased activity in the mid and long end of the yield curve will help improve liquidity in the marketplace not just for dealers but also customers.

The 30-year LGB bond futures contract, combined with the 2-year, 5-year and 10-year, offers a number of interesting trades other than buying and selling cash bonds. The contract's quarterly roll and synthetic nature requires a strong basis market, which was addressed in the market making program. The synthetic nature of the contract means that investors have the advantage of margin to free up cash and still exercise delta views on the yield curve.

With the inter-group strategies at MX, investors can trade a number of relative value curve trades, such as the 10y-30y (CGB/LGB), while minimizing execution risk and deploying less capital than one would for cash bonds. This allows investors to take that excess capital and invest it in long corporate bonds, hedge that corporate position by selling LGBs and creating a credit trade.

With the launch of LGB, supplemented by other bond futures contracts along the Canadian listed yield curve, MX has opened up a number of value points for investors to synthetically hedge a position. Whether it is a curve trade or a credit trade, international investors have more opportunities to trade Canadian fixed income and create diversification in their portfolios. And ultimately, this results in sustained liquidity in the marketplace.

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