USD Swaption volume Nov 2023

Nov highlight:

The most interesting USD swaption trade in Nov was the significant reported activity in the 10y10y point, totaling $7.7mm in vega. This volume is close to the previous highs achieved in Mar and Aug, despite overall swaptions volumes being lower in Nov. This activity might have been driven by the significant rally in long-end rates in Nov, leading banks to re-hedge their existing Bermudan callable bond portfolios.

Nov report:

Nov continued the downward trend in reported USD swaption volume since the peak in Aug. In vega, transactions totaling $96mm of vega were reported, down approximately 40% compared to Aug. In gamma, there was a total of $960k in gamma activity, down approximately 20% vs Aug.

Despite the muted volumes in Nov, we noticed an interesting trade when looking at the vega heatmap of the swaption surface. The heatmap shows that 10y10y was the most active vega point for the month, with $7.7mm vega reported, which is 50% more than the second most active point, 1y10y with $5mm vega reported. This is noteworthy since 1y10y is usually the most active point. For example, over the rest of 2023, the total vega reported in 1y10y is, on average, around 20% higher than 10y10y.

As mentioned at the start of this post, the surge in 10y10y activity is potentially caused by the significant rally in long-end USD swap rates during Nov, leading banks with large USD Bermudan callable bonds on their books to re-hedge their vega positions. It’s worth giving some background on Bermudan callable bonds as they are some of the largest positions on many banks’ USD swaption books.

A Bermudan callable bond is a bond that can be called, i.e. cancelled, by the issuer returning the principal amount to the investor on specific dates. Issuers are willing to pay higher coupons on Bermudan callable bonds compared to standard bond because, in theory, they provide optionality to the issuer. If interest rates decline, the issuer can call the bond and re-finance at a new and lower rate. If interest rates increase, the issuer keeps the bond and enjoys a low funding rate compared to the prevailing market. In practice, the banks usually monetize this optionality by selling volatility on interest rates through the USD swaption market.

During periods of low interest rates in the 2010s, many financial institutions in Asia sought assets to hedge their long-dated liabilities, such as pension or life-insurance liabilities. These assets needed to have certain characteristics: (1) long-dated maturity, usually greater than 15 years maturity, to match their liabilities, (2) safety or at least a high credit rating and (3) high-yield. International banks with highly-rated balance sheets issued long-dated Bermudan callable bonds to meet this demand, and it quickly became one of the most important trades in the USD structured notes market in the last decade.

Given that these trades were long-dated, with popular variations having a final maturity of 30 years if not called, many of them are still held on the issuers’ books. This is what we believe is driving the vega activity when long-end interest rates move violently as they did in Nov. Roughly speaking, when interest rates are rising, as they did in the first half of 2023, the issuer is less likely to call the bonds in the near future, making the optionality on rates more significant on the back end of the curve. To monetize this, the issuer would sell long-dated, vega-heavy swaptions. When interest rates are decreasing, as they did in Nov, the probability of calling the bonds in the near future increases again, and the amount of optionality in the far future decreases correspondingly, requiring dealers to buy back the swaptions they sold. Although the exact swaption points that a dealer needs to re-hedge depends on their specific portfolio, it’s likely that many will trade the most liquid 10y10y point as a proxy.

Finally, interest rates have continued to decline into Dec, so we expect more interesting action in USD swaptions in the coming weeks.