The high cost of unfunded duration — and some hope on the horizon

We’ve had a growing number of conversations with clients about the implementation options and costs of “unfunded duration” as they think about managing their hedge ratio. Unfunded duration involves using interest-rate futures, repurchase agreements (repos), swaps, and other synthetic tools to increase duration in a portfolio rather than purchasing cash bonds.

In this note, we explain why adding duration synthetically, through swaps and futures in particular, has become more costly since the global financial crisis (GFC). Further, we detail how our LDI Team thinks about this important implementation consideration for clients targeting a specific duration profile and why several potential developments could meaningfully improve costs. 

Why the hefty price tag?

The cost of unfunded duration — both swaps and futures — is high and has been on a growing trajectory for the past 16 years. At present, 30-year swaps trade ~75 bps rich to equivalent Treasuries. Additionally, the current swap curve is flatter/more inverted than the Treasury curve, resulting in substantial near-term carry and roll costs versus Treasuries (beyond the negative 75 bps in yield differential). Figure 1 shows that 30-year swaps spreads since 2000. They have been in negative territory since 2008. 

It is substantially more challenging to quantify the cost of futures, given the cheapest-to-deliver optionality and quarterly roll. However, most empirical studies suggest that the outcome using futures is roughly in line with swaps (i.e., negative returns), which we would expect. 

Figure 1

The increasing costs are primarily due to fixed income markets getting larger and dealer balance sheets failing to keep up given both regulatory and capital constraints. This has been the core problem since the passing of the Dodd-Frank Act in the wake of the GFC. 

Investor positioning has also been a cost driver. According to analysis by the Treasury Borrowing Advisory Committee (TBAC), persistent demand for Treasury futures from asset managers who are overweight credit and, correspondingly, need to add duration to match their benchmark is likely contributing to the rich valuations of Treasury futures. The TBAC report includes a discussion (starting on page 57) of Treasury futures use by investor type, which gives context for the “cost of futures.”

Our view and three developments that could improve costs 

Given the costs of using swaps and futures, our LDI Team generally thinks plans may want to prioritize physical bonds in matching their liabilities and conduct a cost/benefit analysis to determine how much to extend the hedge ratio synthetically. In discussing completion management with clients, we typically recommend that they consider the combination of US Treasuries, STRIPS, swaps, and futures that can best meet their hedge ratio goals, while keeping in mind the trade-offs of each instrument, including cost and liquidity.

That said, there have been several developments that could meaningfully improve the cost of unfunded duration moving forward: 

1. Centrally cleared repo gaining traction

While still in its early stages, we believe that cleared repo is the direction of travel for the market. While mandatory clearing of repo transactions is at least a year away, some market participants, including Wellington, have been utilizing Fixed Income Clearing Corporation (FICC) repo programs for several years. Figure 2 shows how the Treasury repo landscape has been shifting over time, including recent growth in FICC repo, particularly in 2024.

Figure 2

2. Peer-to-peer trading with nonbank holders

Some relief to the unfunded markets may also come from nonbank holders (asset managers and the hedge fund community) as they pick up more of the trading volumes from the banks. This effectively moves the market more toward peer-to-peer like trading, much in the way equities trade today. The more that nonbank market makers get involved, the greater the potential for the “liquidity costs” of owning cash Treasuries to go down. Moving forward, we expect, and even hope for, more market disruptors in fixed income trading. 

3. Easier capital treatment rules for banks

With the recent change in the US presidential administration, and the expected focus on deregulation, there is the potential for easier capital treatment rules. One that is being discussed is unlimited repo balance sheets at banks.

Find more on the use of synthetic duration, setting hedge ratios, and other related topics, in these papers:

Mind the liquidity (and cost) gap: Revisiting a plan’s hedge-ratio approach

Extra credit for corporate plans: Advanced topics in LDI implementation