market folly

In a previous post we covered hedge fund legend Julian Robertson's updated play on higher interest rates. He calls them curve caps and they are essentially constant maturity swaps (CMS) that you can buy on an institutional level. He likened the trade to buying puts on long-term treasuries and so we showed how you could replicate that play on a retail investor level. However, there are obviously vast differences between that and the exact play Julian has put on. As such, we've got a great guest post for you that shows how you can replicate his play on an institutional level. Not to mention, fellow hedge fund manager David Einhorn recently revealed he is buying similar plays as well.

Various investment banks have been out pitching these plays for a while now, but you can be they've certainly been hitting the pavement even more now that Julian has been so vocal about his play. The following is a guest post from ZeroHedge.com to explain how they are pitching a replication of Julian's play:

"It is no secret that Julian Robertson is not a huge fan of long-dated bonds. In his recent CNBC interview he had some downright nasty words about the back-end of the UST curve, especially if the "downside contingency" case of foreign purchases ceasing, were to pass. However, while many have known about his propensity for the bond steepener trade, his latest trade position is the so called Constant Maturity Swap trade. Moving away from an outright steepener makes sense as it can now only profit from a tail end widening, since the front end of the curve is at zero. Unless Bernanke follows Sweden into negative rates territory, the steepener upside potential has just been mechanically limited by 50%. As for his current preferred iteration of expressing Treasury bearishness, CMS, here is some recent commentary from JR on the topic:

"The insurance policy I would buy is called a CMS Rate Cap, which is the equivalent of buying puts on long-term Treasuries. If inflation happens the way it could, long-term Treasuries are just going to explode. Less than 30 years ago, long-term interest rates got to 20%. I can envision that seeming like a very low interest rate compared to what might occur in the future."

No surprise then, that Morgan Stanley's Govvy desk has started pimping this trade (including some hedged and Knock Out variants) to anyone who wants to imitate that original Tiger. In a recent version of their Interest Rate Strategist, the key proffered trade is precisely Shorting back-end rates, with the following summary recommendations:

• Buy a 5 year Cap on 30 year CMS struck ATM (5.38%) for 105 bps
• Buy a 5 year Cap on 30 year CMS struck ATM. Sell a 5 year Cap on 30 year CMS struck at 8.38%, for a net cost of 65 bps.
• Buy a 5 year Cap on 30 year CMS struck at 5.38% that knocks out in 1 year if 30 year CMS is above 5.38% for 62 bps.

Here is MS' entire modest proposal:

In the past month, longer-dated volatility has declined and longer-dated rates have rallied (Exhibit 1). Getting short back-end rates – with defined downside – is becoming increasingly attractive. We maintain our long-held belief that, in the long run, the curve will steepen significantly, and we continue to believe that long-dated rate caps will benefit from the higher rates and higher volatility that will come from increased Treasury issuance and an end to the public stimulus programs.

Specifically, we propose a selection of the following trades:

• Buy a 5y cap on 30y CMS struck ATM (5.38%) for 105bp
• Buy a 5y cap on 30y CMS struck at 5.38%, Sell a 5y cap on 30y CMS struck at 8.38%, for a net cost of 65bp
• Buy a 5y cap on 30y CMS struck at 5.38% that knocks out in 1y if 30y CMS is above 5.38%, for 62bp

Inflation and long-end supply remain substantial concerns, particularly for longer maturities. Our economists expect 10y UST gross issuance to more than double from 2008 to 2009, and for 30y UST gross issuance to more than triple. After 2009, we also project 10y UST issuance to increase by $40 billion per year, and long bond gross issuance by approximately $50 billion per year (Exhibit 2). This is while the Fed is projected to keep short-term rates on hold in order to stimulate the economy and maintain a steep curve.

We aim to target 30y rates. This is because we project 30y UST gross issuance to keep increasing at a faster pace than 10y gross issuance (Exhibit 2). Moreover, we expect the curve to steepen in periods of high inflation.

We also target longer expiries (3-5y). Two reasons behind this: first, we have been in a secular downward trend in longer-term rates since the mid 1980s (Exhibit 3). This is a trade for us to break out of that range – we expect such a shift to occur over a longer period of time as opposed to in the next year. Second, flows out of lower yielding money market funds into the belly of the curve are expected to keep longer rates bid, at least for the next couple of months, in our view. This is something that we can exploit by entering into a knock-out cap.

In order to play for higher rates, we suggest a 5y cap on 30y rates struck ATM (5.38%) for 105bp. As opposed to a payor swaption, the payout of a cap is linear with respect to rates. For example, if 30y rates in 5y are at 8.38%, then the investor will make 300bp, multiplied by the notional on the cap.

Investors looking to decrease the upfront cost of the option can accomplish this in one of two ways: either by limiting their upside, or by playing the timing of the sell-off in longer-dated rates.

Limiting the upside would involve selling an OTM cap against the ATM cap that the investor is long. For instance, if the investor sells a 300bp OTM cap against buying long an ATM cap, this cheapens the upfront cost of the option to 65bp, or by 38%. Note that OTM skew on longer tails has richened substantially over the past three months. Exhibit 4 graphs the spread between 100bp OTM 5y30y payors and 100bp OTM receivers, normalized by the level of at-the-money vol – the higher this spread, the more expensive payor skew is relative to receiver skew. Over the past three months, OTM payor skew has become increasingly expensive. This is why we prefer monetizing and selling it as opposed to moving the strike of the CMS cap that we’re long further out of the money.

Playing the timing of the sell-off in longer-dated rates would cheapen the upfront cost of the cap by selling a shorter-expiry option against the longer-expiry cap. Flows out of money market funds into the belly of the curve are likely to keep the long end somewhat bid in the near term, in our view. Investors can monetize this by entering into a 5y cap on 30y CMS rates that knocks out in 1y if 30y CMS is above a strike of their choosing. For instance, a 5y cap on 30y CMS struck ATM (5.38%) that knocks out in 1y if 30y CMS is above 5.38% has an upfront cost of 62bp; if investors move the strike of the knock-out to 6%, the cost increases to 79bp. Note that a 2y knockout cheapens the cap even more than the 1y knockout. The principal risks to the outright CMS Cap are either that rates continue to rally, or that vol falls. Note that both of these risks are mitigated with a 1x1 cap spread, or with a knock-out cap. In each of the three trades, however, the maximum downside for investors is equal to the initial premium invested.