If one lesson has been reinforced in the financial community during the past year, it is the significance of risk management and awareness of counterparty risk.
Available only on the CME Globex electronic trading platform, the CME Lehman Brothers U.S. Aggregate Index futures contract is cash settled so managers do not have to worry about acquiring or transferring any underlying assets for delivery.
In the midst of the debt market turmoil and housing market woes, CME Group launched a new tool last September for fixed-income money: futures on the Lehman Brothers U.S. Aggregate Index. The contract serves as the world's first exchange-traded derivative product on a broad-based fixed-income index, bringing together two of the world's most prominent innovators in global finance and risk management.
The Lehman Brothers U.S. Aggregate Index itself dates back to 1986, with data extending back to 1976. The index is the dominant benchmark debt index for the U.S. dollar- denominated, investment-grade, fixed-rate and taxable bond market, which incorporates about 9,000 issues from government-related bonds, corporate bonds, mortgage-backed securities, to asset-backed securities and commercial mortgage-backed securities.
Lehman's index strategy group estimates that more than 90 percent of U.S. money managers are benchmarked to Lehman indexes, including about $2.55 trillion benchmarked to the Lehman Brothers U.S. Aggregate Index. Exchange-traded funds and over the counter derivatives that track the index have been available, but this is the first time futures are available to complement these instruments. Until a regulatory change was passed in April 2006, futures on such indexes were not allowed to complement these instruments.
The futures contract is building liquidity, especially on the sell-side, a process that is typical for a new contract of any kind. But what is important to users like Tom Lee, senior portfolio manager and principal of The Clifton Group, is that portfolio managers can now acquire or reduce exposure to the entire U.S. investment-grade debt market with a single contract. Traders and hedgers also can use the futures contract in a variety of portfolio management strategies.
Another benefit for Lee and other potential users of the CME Lehman Brothers U.S. Aggregate Index futures contract is that futures have now been expanded in the interest rate contract spectrum.
"With all of the bonds it includes, it's difficult to replicate the Lehman index, but this futures contract does it in one package," says Lee, whose firm manages about $20 billion and provides enhanced index and overlay management services to institutional clients.
Futures provide a transparent marketplace that virtually eliminates the counterparty risk of the over the counter market, which has become a greater concern in today's economic climate. Just as equity index futures give portfolio managers greater flexibility in managing stock market risk, CME Lehman Brothers U.S. Aggregate Index futures increase the fixed-income manager's ability to develop strategies to gain or hedge interest rate exposure, rebalance a portfolio or spread against other exchange-traded instruments, such as U.S. Treasury notes, bonds or interest rate swap futures.
As interest in the contract grows and liquidity builds, fixed-income portfolio managers, pension funds, mutual funds, banks, hedge funds, proprietary trading firms and other entities in the fixed-income universe will benefit from the product. They can use CME Lehman Brothers U.S. Aggregate Index futures to respond to cash inflows or outflows quickly by adjusting their fixedincome exposure and can use the CME Lehman index futures in conjunction with other interest rate futures to create and trade synthetic investment-grade portfolios.
For example, portfolio managers who are concerned about the effect of cash flows on performance can use CME Lehman Brothers U.S. Aggregate Index futures to minimize the impact of transitions of cash into or out of their portfolios or the effect that transaction costs and tracking errors have on their portfolios if they try to replicate a bond index.
Additionally, they might appreciate the transition management feature of futures when they want to shift allocations from equities into fixed-income securities benchmarked to the U.S. Aggregate Index. It might take a number of cumbersome and expensive transactions to achieve their goal, whereas CME Lehman Brothers U.S. Aggregate Index futures can help them accomplish the shift conveniently with a minimum amount of time and expense, while maintaining full market exposure for the portfolio during the period when the transition is occurring.
Available only on the CME Globex electronic trading platform, the CME Lehman Brothers U.S. Aggregate Index futures contract is cash settled so managers do not have to worry about acquiring or transferring any underlying assets for delivery. The contract size is $100 times the index. With a recent reading of about 1,400 (1986 inception date = 100), the futures contract is valued at $140,000.
While overlay services is a growth area for his firm, Lee looks forward to the day when there is a nice mixture of supply/demand and sellers can bring their currently "rich" ask price closer to the buyers' bid price so he can trade CME Lehman Brothers U.S. Aggregate Index futures in size. That two-way flow is still developing after the first few months of trading, but Lee is optimistic that will come about in the future as market conditions evolve - just as stock index futures matured into some of today's most active futures products after slow starts. For more details about the Lehman Brothers U.S. Aggregate Index and the futures contract, see: www.cmegroup.com and www.lehman.com
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