US Treasury futures holdings among mutual funds have shot up over the last three years, as they adjust to a “higher for longer” interest rate context, using the leverage embedded in futures to boost returns.
That’s according to Federal Reserve Board of Governors’ research, which used mutual funds’ own data to estimate that they held approximately US$500 billion in Treasury futures as of Q4 2023 – a 67% increase against Q4 2020. The majority of that increase came in shorter tenor Treasury futures, primarily two-year and five-year Treasury futures.
The research, “Why Do Mutual Funds Invest in Treasury Futures?”, was written by Fed analysts Benjamin Iorio, Dan Li and Lubomir Petrasek. They said: “The recent rise in mutual funds’ futures holdings reflects both their increased demand for Treasury exposures and an increased preference for sourcing these exposures through futures.”
The Fed trio posited several reasons for the increased preference for futures among mutual funds.
The leverage embedded in Treasury futures allows funds to reduce the amount of capital required to maintain a position. Futures may be preferred for interest rate risk management because of their greater liquidity relative to cash Treasury securities.
“Some mutual funds, such as those with volatile investor flows that require frequent adjustments to interest rate exposures may prefer to allocate a greater share of their Treasury exposures in futures since adjustments to futures exposures tend to be easier to implement and less costly,” they said.
Third, mutual funds can use Treasury futures as an asset allocation tool. Funds that obtain their exposure to interest rates in the Treasury market through the use of futures can allocate more of their portfolios to corporate bonds and other securities that offer higher yields. The staffers confirmed this trend using data from the mutual funds’ SEC filings to analyse the characteristics of funds that invest predominantly in Treasury futures and compare them with those of funds that predominantly hold Treasury securities.
“Funds that obtain most of their Treasury exposures through futures invest in more non-Treasury debt and take on more credit spread risk exposure. This is consistent with mutual funds’ reaching for yield as it indicates futures users’ propensity to buy riskier credit to achieve higher yields in the corporate bond market.”
“Overall, this comparative analysis shows that futures usage in mutual funds is associated with greater risk taking, greater flow volatility, and higher expense ratios. These findings suggest that although mutual funds have various uses for Treasury futures, many funds use the embedded leverage in futures to increase portfolio risk and reach for yield.”
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