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Riding The Canadian Yield Curve

By Robert Hunter

Tales of rich skiers being helicoptered to the top of snow-capped Canadian mountains may be getting some press these days, but real thrill seekers may want to try an even steeper slope this winter—the Canadian yield curve.

In the past year, the spread between two-year Canadian bond futures and 30-year bond futures has been as high as 350 basis points, making for the second-steepest yield curve in the industrialized world. Only the land of Mount Fuji boasts a steeper slope.

What's more, Canada's interest rates, for the first time in memory, are lower than those of the United States all the way to 30 years. Relatively high unemployment, uncertainty about Quebec secession and general lackluster economic performance have all pushed Canadian short-term rates to astonishingly low levels over the past three years. This year, however, the economy began to pick up steam. Even though inflation concerns are lower now than a couple of months ago, the yield curve predicts interest rates will rise about 150 basis points in the next 18 months.

Given a healthier economic outlook and the possibility of fundamental changes in the Canadian polity down the road, the question is not whether the Bank of Canada will raise interest rates, but when. A constitutional debate is expected in the next two years, and, according to some, the Quebec issue is only temporarily solved. "If we have another separation dynamic,” says John Kattan, managing director of financial products at CIBC, "things are going to get very volatile.” He thinks that could happen as early as next year.

Normally, a widespread consensus that rates were going up would entice interest rate players to put on some curve-flattening trades.

But it takes two to tango, and many people have decided to sit this dance out. "The international community is very much taking a wait-and-see approach to the Bank of Canada,” says Andy Dickison, head of Canadian dollar swap trading at the Bank of Nova Scotia. "They know it's going to tighten, but there's no interest in trying to guess when because once it starts it has a lot of tightening to do. It's difficult to get ahead of that expectation and make any money. Everyone is prepared for the move, and that's generally when markets don't move a lot.” Particularly since the yield curve has moderated in recent months, down from a high slope of 350 basis points.

Investors are finding the typical approach of buying short and investing the cash overnight is a very expensive proposition. In Canada, the bank rate in late September was 3.25 and the two-year rate was roughly 4.80, making for a costly spread. "It's expensive to be short,” says Dickison. "You're giving up about 155 basis points, if you go ahead and sell two years and invest the cash on an overnight basis.” No one wants to be long, and it's expensive to be short. That doesn't leave a lot of room for maneuvering.

"The international community is very much taking a wait-and-see approach to the Bank of Canada. They know it's going to tighten, but there's no interest in trying to guess when because once it starts it has a lot of tightening to do. It's difficult to get ahead of that expectation and make any money. Everyone is prepared for the move, and that's generally when markets don't move a lot.”
Andy Dickison
head of Canadian dollar swap trading,
Bank of Nova Scotia

But while everyone expects the bank of Canada to raise rates, it still has not bridged the critical gap between thought and action. "The yield spreads between five-year bonds, 10-year bonds and 30-year bonds are quite wide, so the curve is still, on a historic basis, quite steep,” says Dickison. "It's also extremely steep in the very front end.” The longer the Bank of Canada waits to raise rates, the more the curve will steepen, making curve-flattening trades all the more attractive. The window of opportunity to make such trades may remain open for a while longer.

Tools of the trade

Players who hold the view that rates won't rise as quickly as the yield curve predicts have a number of instruments in their derivatives tool kits to exploit the situation—from the prosaic to the relatively exotic.

Because of the relatively underdeveloped derivatives market in Canada, many corporates and banks stick to plain vanilla strategies. There is a common—and decidedly conservative—tendency among traders in Canadian bond plays to remain duration-neutral. While spreads may be fatter longer out the curve, long-term plays are balanced with shorter ones to avoid excessive interest rate exposure. The hedge ratio in most Canadian banks is 4:1, meaning that if a bank buys 100 10-year bonds, it has to sell 400 two-year bonds to be impervious to up-and-down shifts in the interest rate market. But carrying costs for two-year bonds are nearly prohibitive. "You earn more by being long 10-years, but you have to be short four times as many two-years, so it does cost you quite a bit to carry those trades,” says Mark Caplan, managing director of North American trading, global financial products at Bank of Montreal. "That makes it quite difficult to exploit them, unless you get some relatively quick trades to carry away a lot of the value of the curve.”

The simplest method for those who believe rates will rise involves buying BA futures, which are similar to Eurodollar futures except with shorter expirations. In late September, the BA futures curve showed a 150-basis-point spread in short rates out one year. In the simplest scenario, those who believe rates will not go up that high would buy the contract, while those who thought the opposite would sell.

A calendar spread is a more sophisticated tool. The yield curve implies a 150-basis-point jump in short rates in the next 18 months. If you thought short rates would only go up by, say, 50 basis points between now and next winter, you could sell the very front contract—the December 1997–March 1998 contract—and buy the September 1998–December 1998 contract or the December 1998– March 1999 contract. Making a calendar spread expresses the view that while rates may increase 50 points in the next three months, they will not increase by the full 150 points the yield curve implies in the next 18 months.

The most straightforward swap strategy involves simply paying fixed and receiving floating on a vanilla swap. If interest rates rise, you'll profit by receiving an increasingly higher payout. A variation on that technique involves cancelable swaps, in which a trader contracts to pay fixed and receive floating but reserves the right to cancel after a number of years. These are less risky than fixed-for-floating swaps because there is always an escape hatch, but they are less lucrative for the same reason—once rates move adversely, the contract can be terminated.

Another variation on this theme is an arrears swap, in which you contract to pay floating interest in arrears. In traditional swaps, floating rates are set in the beginning of the period, but in arrears swaps the floating rate is set at the end of the period. "You get paid for the implicit slope in the period,” says Mike Bowick, head of trading at the Royal Bank of Canada. "If you don't believe that rates are going up as fast as the curve implies, you get paid for extra curve that doesn't materialize if you're right. We've done a lot of that.”

Forward-start swaps involve a similar strategy. You contract today to buy, say, a three-year bond at the one-year rate plus a certain spread in two years' time. Suppose you elect to receive the three-year bond at the one-year rate plus, say, 50 basis points. If rates go up, and the yield curve flattens, the one-year rate will be considerably higher in two years, but you will have already locked in your price at the earlier rate plus 50 points. That would leave you with the difference between the 50 points already contracted for and the spread in two years' time. "We don't see a lot of those, but when they happen they're fairly significant,” says Dickison. "You'll get very large tickets written.”

There are various option strategies for betting on the yield curve as well. One of the most effective involves purchasing an over-the-counter spread option, also known as a "spreadtion.” It can be structured to pay out if the yield curve narrows—or, conversely, widens—to a certain point. Another strategy is to buy a knock-out cap. A player buys a BA bond on the short end—say a 6.5 percent cap for five years. To lower the cost of the contract, the player agrees to a knock out—or termination—provision when rates go to 8.5 percent. If the interest rate exceeds 8.5, the cap disappears.

There are ways to make other, less-specific directional yield curve plays as well, using call spreads. Traders who are not sure if rates will rise but believe that the yield curve will flatten can sell call options on 10-year paper and buy calls on, say, two-year paper. If interest rates rise, the two-year calls become more valuable, while the 10-year calls become less valuable. But if interest rates stay the same, the 10-year calls retain their value while the two-year calls decline.

Corporates have a number of tools at their disposal as well. The classic fixed-for-floating swap is the most common. When issuing new paper such as, say, a 10-year fixed-rate debenture, corporates who believe the yield curve is poised to flatten could enter into interest rate swaps to convert the fixed coupon to a floating rate at the Canadian BA rate of interest. "The all-in cost of doing that today remains attractive notwithstanding the recent flattening in the yield curve,” says Kattan.

Dealers say corporates are also doing a lot of differential swaps, exploiting the interest rate differential between Canada and, say, the United States. Canadian interest rates are below those of the United States all the way out to 30 years. Diff swaps allow corporates with a lot of U.S. dollar holdings to pay the lower Canadian rate and receive the higher U.S. rate in Canadian dollars. In addition to extracting pure interest rate premium, this play reduces currency risk as well. "Diff swaps eliminate the currency element of the yield trade between two currencies,” says Caplan, "but they allow you to pick up the differential. They are mainly for people who don't want any currency exposure.”

While the Canadian yield curve appears poised to flatten in the coming months, dealers warn that forward prices are seldom accurate predictors of future events. "The short end and the long end in Canada are really trading on different things at this point,” says Caplan. "The long end is trading on the U.S. market, and all of the good news that's built into there.” On the short end, however, the curve is trading much more based on the expectations of the Bank of Canada. "From a trading perspective you'd want to have your trades bias you toward a flatter curve,” he says. But a stronger Canadian dollar could give the Bank of Canada pause, keeping the stubbornly steep yield curve around well into next year.