1. The Real Returns Report Oct. 9, 2011
DINING ON A RICH SPREAD
Global Macro Portfolio: Alpha Opportunity in U.S. Fixed Income
Trade idea Structured Products Version (Underlying) Alex Dumortier, CFA
Long iBoxx $ High Yield Corporate Bond Index +1 (202) 730-6643
alex.dumortier@gmail.com
Short Barclays Capital 3-7 year Treasury Bond Index
ETF Version
Long iShares iBoxx $ High Yield Corporate Bond
Fund (NYSE: HYG)
Short iShares Barclays 3-7 Year Treasury Bond
Fund (NYSE: IEI)
Trade type Mean reversion/ Positive carry
Expected 12-24 months
timeframe
Expected 12%-20% p.a.
return
Sometimes the first duty of intelligent men is the
restatement of the obvious. –George Orwell
We focus on identifying wide mispricings for two reasons:
1. Arbitrageurs are specialists, global macro investors are
generalists. Large, ‘obvious’ mispricings are the only ones
that generalists are qualified to identify.
2. Wide mispricings equate to significant opportunity!
Today, an obvious mispricing exists with regard to credit risk in the
U.S. high-yield market. However, simply stating that something is
obvious doesn’t make it so. In financial markets, what looks like a
honey pot can swiftly turn into a bear trap, but the evidence
suggests this trade will provide satisfaction, not injury.
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2. The Real Returns Report Oct. 9, 2011
VARIANT PERCEPTION
The current generation of bond traders/ investors has never experienced Treasury yields at anywhere
near today’s ultra-low levels, which is the source of some confusion:
 Under “risk on”, investors have been (mis)pricing high-yield bonds on a spread basis against
Treasuries, without giving due consideration to the absolute level of yields. That’s how the
market was able to accept sub-7% yields (Merrill Lynch High Yield Master II Index) earlier
this year, at a time when the economy is still struggling with the aftermath of the popping of
the largest credit bubble in history.
 Conversely, under “risk off”, high-yield investors let their eye off the credit spread and switch
focus to the absolute level of yields. With the yield spread now exceeding 850 bps, that’s
where we are today.
Furthermore, it appears that the dominant factor in explaining the current risk premium on U.S.
junk bonds is not default rates, credit availability or economic activity (the three factors in the
Fridson-Kong model), but instead the European sovereign debt crisis. For example, from May
through September, the correlation between daily returns of the BofA Merill Lynch U.S. High Yield
Master II Index and the CAC-40 stock index in Paris was 98%. Risk assets worldwide are now
marching under a banner that reads “We are all Europeans now.”
The European crisis is certainly serious and it has an (indirect) impact on U.S. junk bond issuers;
however, we don’t think the link is as significant as the price action indicates. We believe that neither
junk bonds’ current fundamentals, nor even a dour forecast of their evolution warrants the risk
premium the market is now awarding them.
THESIS
On May 11th, I wrote:
“The FT notes that junk bond yields are now at record lows by some measures. Granted, the
spread to Treasuries is still twice what it was at the height of the credit bubble, but when
Treasury yields are this low, one needs to wonder if it is enough to price junk bonds on a
relative basis. Junk bond investors should ask themselves: Forget the yield on Treasuries,
does a sub-7% yield really qualify as high-yield?”
Since then, the pendulum has swung hard from “risk on” to “risk off.” Junk bond mutual funds and
ETFs have suffered massive outflows, driving the yield from 6.82% to 9.78% at Friday’s close (BofA
Merrill Lynch High Yield Master II Index.) However, that change understates the increase in the
yield spread as the flight to quality has driven Treasury bond yields to record lows. Consequently, the
spread over governments has exploded from 482 bps on May 11th to 855 last Friday.
The case for being long high-yield bonds and short Treasuries is already compelling. At its current
level, the spread is roughly .8 standard deviations from its historical mean of 600 bps and well
within the top quintile of daily values dating back to the start of the 1997. Flare-ups in the European
sovereign debt crisis look virtually inevitable, so there is every reason to believe the spread could
widen over the short term, providing even better levels at which to put the trade on. Over the
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3. The Real Returns Report Oct. 9, 2011
medium/ long term, however, spreads this wide are highly unlikely to persist; mean reversion is a
reality in this market.
In order to get some idea of the returns the trade might generate, the following table describes the
record of high-yield bonds’ outperformance with regard to equivalent duration Treasury notes over 3
different timeframes once the yield spread over government securities exceeded 850 bps:
Merrill Lynch High Yield Master II Index outperformance against the U.S. Treasury Current 5Yr Index, 1998 –
Q3 2009
1 year 18 months (Ann.) 2 years (Ann.)
Average +25.2% +19.8% +16.7%
Minimum (30.5%) (18.0%) (8.9%)
Worst Monthly Loss (17.5%) (17.5%) (17.5%)
Worst Quarterly Loss (24.5%) (24.5%) (24.5%)
Strategy Sharpe Ratio,
-- -- 1.33
Average
Source: Aleph Advisors, BofA Merrill Lynch
Those numbers suggest the trade is already compelling, on an unleveraged basis, for investors who
can adopt a relatively long time horizon and are comfortable with some degree of volatility. The trade
is inappropriate for investors who are either highly leveraged (more than 1.5 or 2 to 1), or who cannot
tolerate some significant volatility in mark-to-market losses on a monthly or quarterly basis (in other
words, almost every hedge fund.)
Once the yield spread exceeds 1,000bps – which we could very well witness over the next 3-6 months
– the risk/ reward has historically been very favorable, as the next table shows:
Merrill Lynch High Yield Master II Index outperformance against the U.S. Treasury Current 5Yr Index, 1998 –
Q3 2009
1 year 18 months (Ann.) 2 years (Ann.)
Average 39.6% 28.7% 24.2%
Minimum (16.6%) (0.4%) 5.1%
Strategy Sharpe Ratio,
-- -- 1.77
Average
Source: Aleph Advisors, BofA Merrill Lynch
We believe it is worth initiating this trade now, and waiting patiently to fill out the positions as the
credit spread widens.
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4. The Real Returns Report Oct. 9, 2011
W HAT IF THE YIELD SPREAD DOESN'T REVERT TO THE MEAN?
If the yield spread doesn’t revert to the mean, there are two possibilities:
1. The yield spread remains in a tight range around the level at which the trade was initiated.
This outcome isn’t problematic: The carry on the trade is attractive on stand-alone basis.
2. The yield spread widens significantly and remains there for an extended period of time (i.e.
beyond the timeframes we’ve considered in this report.) This outcome is unlikely:
Historically, even yield spreads at current levels have not persisted for that long. At levels
significantly higher, the likelihood is even smaller. Nevertheless, we can’t dismiss this risk
entirely – we know from experience that deviations from the mean in financial markets can
persist for many years.
For a more thorough discussion of mean reversion in this context, please refer to the following
section.
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5. The Real Returns Report Oct. 9, 2011
APPENDIX: IS THE YIELD SPREAD MEAN-REVERTING?
Although we aren’t systematic traders, this trade idea is partially predicated on the expectation that
the high-yield spread will revert to the mean. We tested the monthly yield spread series for
stationarity using the Augmented Dickey-Fuller test, with the following results:
The monthly series of the BofA Merrill Lynch High Yield Master II Index option-adjusted
H0
spread (OAS) is non-stationary
DF statistic (2.9418)
p-value .1830
Lag order 5
Source: Aleph Advisors
With a p-value of .18, we can’t reject the null hypothesis that the yield spread is a non-stationary time
series; however, 4:1 odds against isn’t bad, particularly when they’re bolstered by an economic
rationale. We’re not testing random data series in the hope of finding mean reversion. We suspect
that the high-yield spread is mean-reverting because it is a shared property among other valuation
indicators such as Shiller’s P/E10, which property is a manifestation of the fear/ greed pendulum
that animates investors. Incidentally, the same remarks apply to the yield spread series for the BofA
Merrill Lynch Euro High Yield Index, which exhibits similar statistics:
The monthly series of the BofA Merrill Lynch Euro High Yield option-adjusted spread
H0
(OAS) is non-stationary
DF statistic (2.8859)
p-value .2063
Lag order 5
Source: Aleph Advisors
We looked for additional confirmation with another statistical test. At 0.85 and 0.91, respectively,
the Hurst exponent of these two series indicates long-term positive autocorrelation (‘trending’),
which is contrary to our mean reversion hypothesis. This result – which is surprising -- could be due
to the choice of the time period (the OAS data only goes back to December 1996.) Since 1997, we’ve
experienced quite a few crises: The Asian crisis and LTCM, the bursting of the tech bubble, and the
mother of them all, the credit crisis. Perhaps this density of crises is distorting the distribution (one
has to be very careful with that type of argument; arguably, a ‘distortion’ that has a measurable
impact over a fifteen-year period is part of the distribution, not a deviation from the distribution.)
Deviations from the mean can last a very long time in asset markets. For example, Robert Shiller’s
P/E10, which is one of the only reliable indicators of long-term value, indicates that U.S. stocks were
overvalued on a virtually uninterrupted basis during the 1990s and the 2000s [Instead of using 1-
year earnings estimates, the P/E10 uses a trailing ten-year average of earnings over the prior ten
years.] This shows up when we run the Augmented Dickey-Fuller test on the monthly P/E10 series
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6. The Real Returns Report Oct. 9, 2011
over two different periods, the full history beginning in 1881 and the period December 1996 to
September 2011 (the sample period for the yield spread series:
H0: The monthly series of the P/E10 is non-stationary
Full History Last 15 Years
Sample period
1881 – Sep. 2011 Dec. 1996 – Sep. 2011
DF statistic (3.5648) (2.7917)
p-value .0036 .2457
Lag order 11 5
Source: Aleph Advisors, Robert Shiller
When we consider the entire series, the P/E10 exhibits stationarity at a statistically significant level
(i.e. with a p-value of less than 0.5%, we can comfortably reject the null.) Conversely, the sub-series
that covers the period we used in our analysis of the yield spread doesn’t.
This research is based on current public information that we consider reliable, but we do not represent it is accurate
or complete, and it should not be relied on as such.
This research does not constitute a personal recommendation or take into account the particular investment
objectives, financial situations, or needs of individual clients. Clients should consider whether any advice or
recommendation in this research is suitable for their particular circumstances and, if appropriate, seek professional
advice, including tax advice. The price and value of the investments referred to in this research and the income from
them may fluctuate. Past performance is not a guide to future performance, future returns are not guaranteed, and a
loss of original capital may occur. Certain transactions, including those involving futures, options, and other
derivatives, give rise to substantial risk and are not suitable for all investors.
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