Bonds & bold: Bullets bite back

Covered bullets have become more attractive than callables for both outright and leveraged investors as higher volatility has punished callable bonds and spread widening has lifted bullets' expected returns.

• Rising rates and volatility have hurt bonds, especially callables, while longer covered bullets have gained relative-value appeal as their spreads widened.
• The return on a repo-funded 4%56 position, with rate risk hedged through swaps, is close to zero year to date, even though volatility is at its highest level this year and in several years while OAS remains relatively low.
• Expected return on leveraged covered bullets has risen to 7.6% from 6.3% at the beginning of August, mainly because spreads widened rather than because short rates increased.
• NYK Jul31 has delivered a return just below zero since early August despite a 6–7 bp widening in generic 5.5-year spreads, implying a 1.3 percentage-point increase in expected return over two months with little performance cost.
• Since August, five-year covered-bond spreads widened 7 bp against DESTR swaps while 10-year Danish government-bond spreads tightened 7 bp, supporting the Danish government bonds as a tail-risk hedge rather than a general hedge.

Takeaway: Investors should prefer Danish covered bullets over callables, although upcoming refinancing auctions, a declining net position in Q1 and weak euro covered bonds could create further spread pressure and reallocations toward EUR assets.