Repression, Compression, Expression

Investors should consider adding short volatility as a source of carry.

When the European Central Bank announced its plan for quantitative easing (QE) on 22 January 2015, it joined the ranks of central banks, including the Federal Reserve, the Bank of England and the Bank of Japan, that have embarked on unprecedented sovereign bond purchase programs in the hopes of stimulating their economies and fighting off deflation. This has driven yields down to historically low levels. Some regimes, such as the ECB and the Swiss National Bank, have gone further by instituting negative short-term interest rates. With the Fed acknowledging “international” developments in their last Federal Open Market Committee (FOMC) statement, financial repression is now a truly global phenomenon.

Yields are compressed and highly correlated, and volatility has risen
With 10-year German Bunds and 10-year Japanese government bonds yielding below 0.50%, 10-year U.S. Treasuries look attractive, even at 1.95%, to foreign investors (see Figure 1). And as the dollar index has strengthened, in no small part due to these new QE programs and other currency intervention, foreign capital has flowed into U.S. Treasuries and other U.S. asset markets. Thus, the cumulative financial repression has led to compressed and recently highly correlated yields in most developed countries, while markets have been volatile as investors react and adjust to the new environment. However, these recent short-term spikes in realized and/or implied volatility belie likely damped volatility at these low rates over time, suggesting a potentially attractive opportunity to sell longer-term volatility at current premiums.

Through this recent bout of market turbulence, implied interest rate volatility has remained well bid as investors look to hedge risks by buying options (insurance) against both a further decline in rates and a sharp reversal higher in the rates market. This is an interesting development from a historical perspective: Throughout the recent financial repression era starting with the second round of U.S. QE at the end of 2010, volatility has declined along with declining yields as we approach what was thought to be a “zero-bound” in interest rates. But with negative interest rates in France, Japan and Germany (see Figure 2), many have questioned if a zero boundary still exists in the US.

Amid this potentially deflationary environment, the negative interest rate tail in the US is more likely, but with US unemployment at 5.7% and GDP of 2.6% and 5% the last two quarters, we think any market perception that there is a chance the Fed will ease financial conditions is off base. In fact, we expect the Fed to begin to raise rates this year.

Selling options versus buying U.S. duration
For investors looking to add yield to portfolios, the low level and recent high correlation of global government bond yields, combined with the relatively high level of U.S. implied rate volatility, potentially make selling options more attractive than being outright long U.S. duration. Selling options may also offer a significant carry offset against a backup in rates in the U.S. market. This is particularly attractive for investors who believe that the U.S. economy will continue to outperform its global counterparts, since any increases in U.S. yields will likely be limited by the overall low global rate environment. While implied volatility levels are far from past highs, they do exhibit a larger premium relative to current rate levels than they have in the past (see Figure 3). It’s clear that given the recent linkage of global government bond markets, the level of U.S. rate volatility is quite high.

Now let’s look at the potential outcomes for selling 2y10y swaption straddles in the U.S.. While we could evaluate many different options, we focused on two-year straddle options on the U.S. 10-year swap rate, which currently trade at 858 basis points (bps). At expiration, this combination implies a terminal breakeven of 96 bps around the strike, currently 2.46%, or a breakeven range of 1.50% to 3.42% on 10-year swap rates. While the forward two-year/10-year rate has traded above our 3.42% breakeven several times in the past five years, the spot 10-year rate has been well contained within the breakeven band on both the high and low side since 2011 (see Figure 4). Simply put, as long as we are above 1.98% on the 10-year swap rate at expiration, the straddle sale will outperform the duration long in the same underlying forward rates. Furthermore, the straddle sale will outperform the U.S. duration long in all the scenarios above 1.98% on the 10-year rates at maturity.

Investors should consider adding short volatility as a source of carry
Historically, investors have looked at shorter-dated option sales as a preferred carry strategy. While we still believe short-dated option sales may be tactically favorable, ongoing global adjustments and policy moves may create ongoing short-term volatility in the near term, and longer-dated options sales are likely to outperform long duration strategically until the period of financial repression, global deflation concerns and yield compression has ended.

Since a return to 2012 yield levels in the U.S. will eventually result in lower volatility, now may be the time for investors to consider adding short volatility to their portfolios as a source of carry rather than being simply long duration. This may also help hedge against any potential selloff if economic data improves in the eurozone and inflation expectations rise due to QE.

The Author

Rick Chan

Portfolio Manager, Interest Rate Derivatives

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Past performance is not a guarantee or reliable indicator of future results. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. High-yield, lower-rated, securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Derivatives and commodity-linked derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Commodity-linked derivative instruments may involve additional costs and risks such as changes in commodity index volatility or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. Investing in derivatives could lose more than the amount invested. Tail risk hedging may involve entering into financial derivatives that are expected to increase in value during the occurrence of tail events. Investing in a tail event instrument could lose all or a portion of its value even in a period of severe market stress. A tail event is unpredictable; therefore, investments in instruments tied to the occurrence of a tail event are speculative. Swaps are a type of derivative; swaps are increasingly subject to central clearing and exchange-trading. Swaps that are not centrally cleared and exchange-traded may be less liquid than exchange-traded instruments.

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