THE JUMBO CONTRACT
Derivatives on pfandbriefe--the German mortgage bond market--have recently been opened up by the launch of a jumbo futures contract on the Deutsche Terminbörse. Jumbos are pfandbrief with a minimum size of DEM1 billion (USD588 million) and a straight bullet structure. All triple-A rated jumbos with at least three and a half years to maturity will be considered deliverable. Trading starts July 6, with September 10 as the first delivery date. We stated in an earlier Learning Curve (DW, 4/13), that the jumbo future will open the door for a liquid market for pfandbrief derivatives and described possible trading strategies in general. It is now--just before the introduction--a good time to analyze the impacts of the new contract on the underlying market, and how to exploit them.
LIQUIDITY
Given the size of the average deliverable jumbo pfandbrief, some DEM1-2.5 billion, liquidity is a concern. However, the new future is the only pfandbrief hedging instrument not subject to credit spread risks, such as swaps or Bund futures, and that offers low transaction costs. Given the size of pfandbrief portfolios--altogether DEM1.3 trillion outstanding--there could be significant hedging interest, particularly on the cheapest-to-deliver jumbos. If liquidity of the CTD issue is not sufficient, there will be a richening of the CTD jumbos versus the basket until enough bonds are trading around the switching point, providing the necessary liquidity for delivery. Assuming a moderate open interest, about 10 jumbos would have to trade around the switching point to meet liquidity needs. This would correspond to a theoretical potential richening of up to 10 basis points for the current CTD issues in the December contract DHYP 4.75% 06/02 (AAA) and DEXIA 4.25% 07/02 (AAA). These issues also play an important role in the delivery into a possible September contract and could therefore profit twice from limited liquidity. Furthermore, the lack of a liquid repo market should lead to first, tight repo rates for deliverables, allowing attractive refinancing, and second, a high volatility of repo rates, resulting in frequent and CTD switches.
THE TAPPING OPTION OF JUMBO ISSUERS
Given the likliehood of a richening, the German mortgage banks have an incentive to make use of their option to tap deliverables. However, neither tapping nor issuance of new deliverables is allowed after the last trading day of the month before delivery. Therefore we anticipate banks tapping squeezed jumbos to limit the squeeze potential at the beginning of each contract. We also believe there is a possibility of dramatic squeezes during the last two weeks before delivery.
THE SPREAD OF JUMBOS VERSUS 'CLASSICAL' PFANDBRIEFE
The chart shows the yield spreads between classical pfandbriefe and Bunds as well as between jumbos and Bunds. We observe the delivery premium, already causing tight spreads in the five year sector versus Bunds, while there is no distinction between classical pfandbriefe and jumbos yet.
As a jumbo contract likely will lead to a split between illiquid classical pfandbriefe and 'Bund-like' jumbos, we expect medium-dated jumbos to outperform classical pfandbriefe as they already have versus Bunds. This development likely will also be supported by demand from foreign investors for liquid (deliverable) jumbos with higher yields than Bunds and offering, in future, a similarly efficient market. It is attractive to switch out of classical pfandbriefe into deliverable jumbos now.
THE SPREAD OF JUMBOS VERSUS BUNDS
The spread between jumbos and Bunds is driven by two factors. First, different credit qualities and second, market direction. As the jumbo market has been comparatively illiquid until now, it has a delayed reaction to yield shifts in the Bund market. This causes an outperformance of Bunds versus jumbos in a rally and vice versa in a sell-off. Simple arbitrage (via futures contracts) between the two markets should lead to a convergence between jumbo and Bund volatility. Hence the jumbo future will put an end to the current spread pattern caused by market direction. In the future, the spread between jumbos and Bunds likely will be determined exclusively by the demand for paper of different credit qualities.
This week's Learning Curve was written by Christian Schaller, strategist in global relative value research at Deutsche Bankin Frankfurt.
