Societe Generale: Bearish Fly Trades With A Tail-Risk Hedge

Societe Generale write “the bear steepening in the global rates markets is causing a risk-off move in Europe, pushing 10y BTP-Bund higher.”

• “Public finances might not be the first to break but will ultimately suffer in such an eventuality as governments provide a backstop to crises. Italy is particularly at risk.”
• “We expressed our bearish view with a widening 10y BTP-Bund target and recommended 2-10y BTP-Bund steepeners,”
• “However, the steepeners can have a major drawback. During a flight to quality in response to a sharp sell-off, 2y BTPs usually suffer the most as markets price a higher probability of a near-term default.”
• “Hedge the sell-off event by selling the belly of BTP-Bund boxed flies, e.g. 2-10-30y BTP-Bund or 5-10-30y BTP-Bund.”
• “These flies seldom drop during a market sell-off, and while they did so in 2011, the decrease was much less than the relative flattening in the 2-10y BTP-Bund.”
• “The choice between 2-10-30y BTP-Bund and 5-10-30y BTP-Bund is purely the trade-off between beta and volatility: the 2-10-30y fly usually has a higher beta with country spreads, but it’s also more volatile. The downside is slightly lower risk-adjusted carry and roll.”