This piece first appeared in the September 2012 edition of
Rep.
magazine
A while ago -- admittedly a long time ago -- hedge fund
customers had all the fun. Investors obtained their non-correlated
giggles through diversestrategies such as trading around mergers,
following futuresmarkets trends, pitting long equity positions
against shorts and, among others,fixed income arbitrage.
Though there hasn't been much joy in Hedgeville over the past
couple of years, some wan smiles could be seen the faces of
investors in 2012. Halfway through the year, fixed income arbitrage
was the best performer among the dozen strategies subsumed within
the Dow Jones Credit Suisse Hedge Fund Index. With interest rates
so low nowadays, it's no wonder that yield-hungry investors would
be especially keen on plays designed to squeeze a little extra out
of the bond market.
In their quest for alpha, hedge fund managers employ a number of
market-neutral arbitrage tactics to exploitvaluation differences
between fixed income securities or contracts.
Fixed Income Tactics
In a typical trade, an arbitrageur starts with a swap in which a
floating rate is paid in exchange for the receipt of a fixed coupon
rate. A second leg consists of a short Treasury bond position
matching the maturity of the swap. The bond sale proceeds are then
invested through a margin account at the "repo" or repurchase
agreement rate. Essentially, the trade is a bet that the fixed rate
remains higher than the floating rate over the swap's life. (When
floating rates are expected to rise, the trades and resulting cash
flows are reversed).
Most commonly, volatility arbitrage entails the sale of options
against a fixed income inventory position. As long as
market-neutrality is maintained (i.e., the delta of the bond and
option positions offset), the excess volatility embedded in the
option premium can be harvested as profit.
-
Capital Structure Arbitrage
Capital structure arbitrage exploits mispricings in an issuer's
securities or changes in market demand for the paper. An arb may,
for example, purchase a company's senior bonds and sell short its
subordinated debt, hoping a bull market narrows the yield
spread.
Hedging mortgage-backed securities with swaps is a common
arbitrage. A duration-weighted hedge isolates the pre-payment risk
embedded in a mortgage pool.
Taking long and short positions at different points along the
yield curve allows a trader to exploit the relative
cheapness/richness of certain maturity buckets or to capture gains
from the wholesale flattening/steeping in the slope.
Among fixed income arbitrage trades, those focused on the yield
curve have drawn the most investor attention recently. The Treasury
curve, in particular, has taken center stage since the Federal
Reserve announced a swap of its short-term paper inventory for
longer-dated obligations under the quaint moniker of "Operation
Twist."
Operation Twist is designed to nudge down long T-note rates.
Since many loans are keyed off these securities, the Fed thinks
this should stimulate spending and borrowing. Mechanically, the
swap flattens the yield curve as the central bank sells Treasury
securities maturing in less than three years and reinvests the
proceeds in notes and bonds maturing six to 30 years out.
So far, it's worked well. At least the curve has flattened (it's
debatable whether the operation's actually encouragedpeople to part
with their cash or to take on debt). From September 21, 2011, when
the program was announced, through mid-2012, a fifth of the spread
between two-year and ten-year T-notes has been trimmed.
Now, you'd think that would be goodnews for the hedgies. After
all, the Fed blatantly telegraphed its intent long before tweaking
its inventory. Traders could have easily piggybacked on the central
bank's open market operation and surfed toward the long end of the
yield curve.
Surprisingly, though, the Dow Jones Credit Suisse Fixed Income
Arbitrage Hedge Fund Index has been pretty much flat since the
Twist party started. The reason? Well, the benchmark's performance
reflects the constituent funds' emphasis on
other
arbitrage styles, i.e., their
de
-emphasis of the Treasury market. No single product in the index
focuses solely on riding the Treasury yield curve waves.
In fact, the pure-play opportunities are available through
exchange-traded products. There are a number of funds and notes
that investors can use either as surrogates for vanilla Treasury
portfolios or as proxies for "twist" operations. Keeping in mind
that past performance is never a guarantee of future results, we
may be able to glean some insight into the relative sensitivity of
these products to future Fed action with a bit of a look-back.
Yield Curve Dynamics
By now, it shouldn't be a surprise that investors scoop up
Treasury paper whenever the global or domestic economy hiccups. The
impact of these "risk off" trades is predictable. In the first nine
months of 2011 leading up to the Fed's announcement of Operation
Twist, the market yield on the ten-year T-note fell more than 30
basis points. Back then, though, investors were more keenly
interested in shorter maturities. Yields on two-year paper dropped
by 40 basis points. All this steepened the Treasury yield
curve.
That all changed with Operation Twist. By mid-2012, ten-year
yields were halved while those of two-year paper actually ticked
up
. All told, the curve between these maturities flattened by more
than 150 basis points in the nine months following the Fed's
intervention.
So what effect did this have on investors? As you might expect,
holders of longer-dated T-notes or their exchange-traded fund
analogs benefited most. The iShares Barclays 7-10 Year Treasury
Bond Fund (
IEF
) rose at a 13.8 percent rate since the beginning of 2011 while its
sibling iShares 1-3 Year Treasury Bond Fund (
SHY
) appreciated by just 1.1 percent (see Table 1).
From the table, you'll readily see the direct relationship
between fund returns and volatility. Here, risk -- at least that
associated with stretching out on theinvestment horizon -- seems
amply rewarded. The IEF fund's higher Sharpe ratio and positive
alpha, compared to SHY, obliquely reflect the yield compression in
the Treasury market over the past 18 months.
Other exchange-traded products more directly trace changes in
the shape of Treasury curve. There's a pair of Barclays Bank notes,
for example, that track the Barclays Capital US Treasury 2Y/10Y
Yield Curve Index. The index simulates a spread between two-year
and ten-year T-note futures.
Holders of the iPath US Treasury Steepener ETN (
STPP
) make money when the spread in Treasury yields widens (i.e., the
curve steepens) while its opposite, the iPath US Treasury Flattener
(
FLAT
) gains when the spread narrows.
The ETNs' underlying index captures these returns through a
notional rolling investment in T-note futures contracts, weighted
75% in the two-year maturity and 25% in the ten-year. The index's
weighted average maturity is four years, making the spread directly
comparable, for benchmarking purposes, to the Barclays 3-7 Year
Treasury Index we've used to gauge the performance of the long-only
Treasury funds.
It should come as no surprise that the implementation of
Operation Twist has been a boon for FLAT investors and a detriment
to holders of the STPP note. Table 2 depicts the portfolio
statistics of both iPath products together with the Dow Jones
Credit Suisse Fixed Income Arbitrage Hedge Fund Index. Here, we've
benchmarked the notes and the hedge fund index to the Barclays
standard over the same investment horizon used in our previous
analysis.
What's noteworthy (an unintended pun), though not really
surprising, is FLAT's positive alpha. The note's 24 percent return
-- better than three times that of the benchmark -- readily swamped
its high beta. With that in mind, you well might ask how the hedge
fund index's negative return still entitles it to positive alpha.
That's also explained by beta. Keep in mind that alpha quantifies a
security's
beta
-adjusted excess return over the benchmark. The hedgies
paradoxically delivered on their promise of non-correlated returns
by keeping their r-squared coefficients low and their betas
negative. Unfortunately, investors can't eat negative beta.
FLAT's return can't be attributed solely to a change in the
contour of the yield curve, though. A curve of another sort
contributes excess return (either positive or negative). Remember
FLAT's underlying index tracks a weighted futures spread. The
underlying Barclays index is nominally long 75 percent two-year
note contracts and 25 percent short ten-year futures, but FLAT
delivers the
inverse
index return, comparable (though not necessarily equivalent) to
holding positions opposite the benchmark.
It's important to recall that holders of futures open interest
must roll their positions from one delivery month to the next as
their contracts approach expiration. This is done to avoid
conveyance of the underlying Treasury notes. For FLAT that means
two swaps are negotiated each calendar quarter: a rough
approximation of rolling forward a long ten-year note position and
a short stance in two-year futures.
More often than not, deferred deliveries of interest rate
futures are priced at a discount to nearbys, reflecting the time
value of money. In such a backward environment (compared to the
contango found in adequately supplied markets for storable
commodities), quarterly rolls of long positions engender
incremental gains while the extension of short postures yields
losses. With rolls, it's nothing more than "selling high and buying
low." The weighting scheme of the index produces overshadowing
gains at each swap, but FLAT investors see a negative roll yield
(remember, the ETN delivers an inverse return) as long as the
T-note futures market remains backwardated.
There's a couple of lessons here. First, a backwardated T-note
futures market favors STPP investors. Second -- really a corollary
of the first -- is that a tip into a contango market turns things
upside down. That's likely if the yield curve inverts (short rates
exceed long rates).
The Future
To manage economic recoveries, the Federal Reserve typically
ratchets up short-term rates, flattening out the Treasury yield
curve. The current environment has hardly been typical, however.
After supplying liquidity for such a long time on the heels of the
2008-2009 crash, there wasn't a lot of maneuvering room left at the
short end, so last year central bankers dug into their playbook to
reprise a 1961 strategy and extended the Fed's direct influence on
maturities further out.
All that's going to end some day. Sooner or later, the yield
curve will reach a sort of stasis, featuring parallel changes on
either end, or will actually steepen. At that point, the utility
and the outperformance of the FLAT ETN will likely be foreclosed.
At some date we may see STPP become the darling of Fed watchers. We
don't yet know if the central bank will signal a course reversal as
well as it telegraphed the onset of Operation Twist. Suffice for
now to know that there are products that can tactically exploit or
hedge against this policy shift.
Fun, right?
Disclosure:
None
See also
'Investing For The Long Run' With This Durable
Sale/Leaseback REIT
on seekingalpha.com