The Hunt for Extra Yield: Bonds or Derivatives?
Recognizing opportunistic dislocations in global bond markets is one of the ways the OppenheimerFunds Global Debt Team seeks to provide additional sources of return and maximize value for investors.

While fixed income investors certainly have a wide range of investment opportunities available to them, choosing a specific debt instrument is almost as important as the specific investment choice. To that end, our global fixed income trading team evaluates not only the issuer, but also the type of security to buy that best reflects the views of the investment team. In other words, bonds or derivatives?

Instrument Overview: Cash Bonds vs. Swaps

Oppenheimer International Bond and Oppenheimer Emerging Markets Local Debt strategies invest in developed and emerging market countries in local currency or U.S. dollar-denominated bonds. The investment process includes a decision regarding the specific investment instrument, that is, whether to invest directly in a particular country’s debt via a cash bond, or a derivative structure such as an interest rate swap (IRS)1 or credit default swap (CDS).2

An asset swap (ASW) is a type of investment security in which an investor purchases a bond while simultaneously paying for an IRS with the same maturity as the bond. These two trades attempt to lock in the spread between the bond and the IRS as a way to potentially capture extra yield. For example, in South Africa, an investor could have purchased in mid-January 2019 a government bond maturing in 2026 yielding 8.80%, and pay for a fixed-rate IRS with a similar maturity profile at 8.00% to lock in a spread of 80 basis points (bps). In this case, the trade would yield 80 bps per year for the duration of the ASW if held to maturity.

In this example, an investor can assume 80 bps of earnings per year for the next seven years. However, the main benefit of the ASW is that it enables the investment team to easily trade between these instruments and take advantage of underlying market dynamics. The ASW allows the investment team to pursue another avenue in an attempt to create value instead of relying solely on cash bonds.

Investors should be aware of the risks associated with investing in IRS, CDS, and ASW, as derivatives may be more volatile than other types of investments.3

Following are case studies4 in which our global debt team put this type of decision-making into action.

Fewer Debt Auctions Create Opportunity in Poland

Towards the end of 3Q18, we saw what we believed to be an interesting opportunity arise in the Polish government bond (POLGB) market. The Finance Ministry announced on Sept. 6 it was limiting debt auctions for the remainder of 2018 because government budget needs had been met. That caused yields on shorter-duration government bonds to rally significantly due to demand from local banks, which are required by regulation to hold Polish government bonds.

Yields on cash bonds tend to be higher than the yield investors may earn by entering into an IRS. This makes sense because investors must use cash to purchase bonds rather than use collateral to enter into an IRS. In this case, the increase in demand for POLGBs changed the usual market pricing and led to a higher yield from an IRS than from cash bonds. Exhibit 1

Exhibit 1: Yield Difference Between Polish Government Bond and a Polish Interest Rate Swap

Exhibit 1 highlights the change in yields between a specific POLGB maturing in 2022 and an ASW with the same maturity. During early 2018, an investor could buy the POLGB, enter into a paid position on a swap, and earn roughly 5 bps per year. After the Polish Ministry of Finance’s Sept. 6 announcement, POLGB yields increased by 27 bps and were higher than IRS yields. However, by late October, the opposite would have been true, with the same position leading to a loss of approximately 23 bps per year.

While 27 bps may not seem large, it is about a 10% greater return on a bond that yielded 2.5%. We were able to take advantage of this anomaly by selling bonds and entering into an interest rate receiving swap position in October 2018.

Fiscal Policy Concerns Affect Mexican Bond Market

Another example of the ASW trade is currently playing out in Mexico, but in the opposite direction from what we saw in Poland. The July 2018 election of Andrés Manuel López Obrador as President of Mexico, and some of his subsequent fiscal policy decisions, have led to investor concerns about Mexican assets. Prior to the election of AMLO, as he is commonly known, foreign investors, who have historically dominated the Mexican government bond (MBONO) market, held roughly 64% of MBONOs. The latest numbers show that foreign ownership of MBONOs has fallen below 60%. Exhibit 2

Exhibit 2: Holders of Mexican Government Bonds

This dynamic has had the opposite impact of what we witnessed in Poland, where bonds have underperformed IRS. At the time of AMLO’s election, bonds traded roughly 35-40 bps below swaps, compared with roughly 15-20 bps currently. Exhibit 3

Exhibit 3: Yield Difference Between Mexican Government Bond and a Mexican Interest Rate Swap

Our global debt team believes this trend may continue, and will attempt to trade both sides of the ASW in an effort to earn additional returns by selling interest rate receiver positions and purchasing MBONOs.

Brazil’s Basis Swap Opportunity

The bond versus derivative swap decision does not apply only to local markets. In the hard currency space (i.e., U.S. dollar-denominated bonds issued by a foreign country), investors can seek dislocations in credit spreads between bonds and CDS, a basis swap. The basis swap looks to capitalize on the spread between assets that are perceived as cheap and those considered to be expensive. A positive basis trade is when the spread of a CDS position is higher than the spread of the bond an investor is hedging. The reverse is true for a negative basis trade.

Political concerns in Brazil prior to the October 2018 elections caused many investors to hedge their positions, which created a positive basis spread of nearly 100bps. Investors could have sold Brazilian government bonds maturing in 2023 (a perceived expensive asset) and increase risk via a short five-year CDS position (a perceived cheap asset) ahead of the final round of elections in October. Since the basis was positive, the investment strategy could have added value when the CDS outperformed in the post-election period, as displayed by the compression of spreads. Exhibit 4

Exhibit 4: Spread Differential of 5-Year Brazilian Credit Default Swap and 5-Year Brazilian Government Bond

Making the Ideal Choice

If the question for global debt investors is bonds or derivatives, in our view the answer is not so straight forward. As the above examples demonstrate, the most suitable choice depends on market conditions, the pricing available at any given time, and other variables, such as political developments that may affect markets and pricing.

The Global Fixed Income team seeks opportunities by continually monitoring each market’s dynamics and the available financial instruments with the ongoing goal of seeking to provide additional sources of return.

  1. ^An interest rate swap (IRS) is a forward contract in which one stream of future interest payments is exchanged for another based on a specified principal amount. Interest rate swaps usually involve the exchange of a fixed interest rate for a floating rate, or vice versa, to reduce or increase exposure to fluctuations in interest rates or to obtain a marginally lower interest rate than would have been possible without the swap.
  2. ^A credit default swap (CDS) is a financial derivative or contract that allows an investor to "swap" or offset his or her credit risk with that of another investor. A credit default swap is designed to transfer the credit exposure of fixed income products between two or more parties. In a CDS, the buyer of the swap makes payments to the swap’s seller until the maturity date of a contract. In return, the seller agrees that – in the event that the debt issuer (borrower) defaults or experiences another credit event – the seller will pay the buyer the security’s value as well as all interest payments that would have been paid between that time and the security’s maturity date.
  3. ^There are risks associated with investing in interest rate swaps (IRS), credit default swaps (CDS), and asset swaps (ASW). Derivatives may be more volatile than other types of investments; may require the payment of premiums; may increase portfolio turnover; may be illiquid; and may not perform as expected. Derivatives are subject to counterparty risk and investors may lose money on a derivative investment.
  4. ^Source: OppenheimerFunds, 3/12/19. For illustrative purposes only. Not all factors will be considered for all transactions or components of portfolios. There can be no assurance that any investment process or strategy will achieve its investment objectives.