Boring Risk

16 Apr

“Know when to hold ‘em, know when to fold ‘em” – My forecast and trade on the 2/30 had called for 400bps by this time from December 09. Clearly things have not worked out as well, which has warranted increased monitoring of this position. Fundamentally, I believe that the spread will eventually go to those levels for the main reasons:

  1. 30Y bonds are not desirable to many investors given increased geopolitical risks, which should put further selling pressure in the (hopefully) intermediate term.
  2. 30Y swaps are inverting more and more, which is reflecting the perception that the US government could possibly not meet the obligations 30 years hence (I doubt we can meet our obligations 5 years hence, and the swaps market seems to be inching closer to that same picture as well)
  3. Investors will begin to demand higher yields due to selling and to try to minimize any potential fallout effects that DC’s fiscal recklessness could dish out
  4. The shorter end of the curve has less default risk, so I would expect that investors who are looking for a relatively short lockup period for their funds can still get a relatively decent rate (it is still beating what most banks are charging for deposits)

Luckily for me, the 360 bps has not been breached much, and due to me being on vacation for the better part of March, I’m glad I didn’t follow the spread from day to day.

My VaR assumptions for the portfolio were shattered nearly 4 times (although if memory is serving me correctly, intraday that number is much higher), with the most recent being in early March. The historical VaR for the spread has been decreasing along with historical volatility. The primary risks that I continue to see for the spread are: 1) Geopolitical risks both in US and EU 2) A shift in the perception of long term US deficits which could make the long end of the curve desirable.

Out of all the spreads, this particular spread has the lowest HV, primarily due to the lack of significant movement in terms of 30Y yields. The short end of the curve has seen recent spikes in HV, and thus if I do an analysis of the portfolio for both 2Y and 30Y, I see that this is validated. The overall Expected Shortfall (ES) is 9.5% at a 95% confidence interval. The contribution of each leg is: 2YR 90%, 30Y 10%. I have suggested in the past in order to hold on to the position to hedge one or both of the legs with options. In February, I initiated the hedge and by March this hedge had expired. It is, perhaps time to try to hedge against volatile moves on the short end, particularly above 1.10% on the 2Y leg and possibly put in a rate floor on the 30Y around 4.60-4.65, This will enable the individual to hold on to the position while attempting to stem losses from continued flattening of the curve due to exogenous factors such as a flight to quality from some unforseen event, etc. I agree with Bill Gross on this one, but of course I am not totally impartial in the debate between BlackRock and Pimco.

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6 Responses to “Boring Risk”

  1. professor pinch April 16, 2010 at 10:36 am #

    Great post. I’ve been talking about legging into hedges on the shot end of the curve for a while now, as I feel the risk is really in the short end of the curve, and the spikes in HV there would seem to back this up.

    Regarding the swap spreads, do you think it’s really a sovereign issue or just extreme complacency in monetary policy? I wrestle with this, but I seem to think it’s more about complacency in rolling over floating rate debt at similar rates.

    Nice SAS graph, too.

  2. chibondking April 16, 2010 at 11:30 am #

    Hey professor pinch-

    I think the swaps, at least out on the long end is due to sovereign issues. Only recently has the mid/short end of the swaps curve approached 0, but that can be explained by the crunch of corporate issuance for the most part. If I recall correctly, at first the 30Y swap inversion was attributed to Yen being ~ 85, and people buying the swap and receiving the cashflows in yen. That’s clearly not the case now with yen weakness. If the sov issue was not a problem, as it was earlier when we saw a “recovery” from the dark days in Oct 08 the gains above 0 in late Dec 08 should have persisted. We went into 2009 with sov risk, which only got louder as the year went on.. That’s my view, feel free to discuss =)

    30Y Swap Spread ts
    2008-12-18 -14.0
    2008-12-19 -3.0
    2008-12-22 1.0
    2008-12-23 6.0
    2008-12-24 8.0
    2008-12-26 10.0
    2008-12-29 4.0
    2008-12-30 13.0
    2008-12-31 0.0
    2009-01-02 -5.0
    2009-01-05 3.0
    2009-01-06 14.0
    2009-01-07 -6.0
    2009-01-08 -12.0

    • professor pinch April 19, 2010 at 10:21 pm #

      chibondking,

      You’re right, the 30yr swap spread has been persistently negative for more than a year. I did a post that looked at this, and I wrestled with it then, just as I do now.

      Don’t get me wrong: I’m not dismissing anything at this point when it comes to understanding the persistently negative swap spreads at the 30yr pt on the curve. And I’m not so naive to rule out sovereign credit issues here in the US.

      Maybe I’m just looking for a panacea and coming up empty…

      Thanks for the reply.

      • chibondking April 19, 2010 at 10:30 pm #

        Sweet, I will take a look at your site as well.. It’s nice to have a fellow soul out there wrestling with trying to understand the inner twistings of the swap spread world.

        -c

  3. RPB April 26, 2010 at 4:12 am #

    why use a non-dv01 2/30 ratio in your analysis?

    • chibondking April 26, 2010 at 8:34 am #

      The risk numbers that I cite for the purposes of positions on each leg take into account DV01 weightings.. The spread numbers themselves are pretty standard

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