Alpha Opportunity: Dining on a Rich Spread, Oct. 9, 2011


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Alpha Opportunity: Dining on a Rich Spread, Oct. 9, 2011

  1. 1. The Real Returns Report Oct. 9, 2011 DINING ON A RICH SPREADGlobal Macro Portfolio: Alpha Opportunity in U.S. Fixed IncomeTrade idea Structured Products Version (Underlying) Alex Dumortier, CFA Long iBoxx $ High Yield Corporate Bond Index +1 (202) 730-6643 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 carryExpected 12-24 monthstimeframeExpected 12%-20% p.a.returnSometimes the first duty of intelligent men is therestatement of the obvious. –George OrwellWe 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 theU.S. high-yield market. However, simply stating that something isobvious doesn’t make it so. In financial markets, what looks like ahoney pot can swiftly turn into a bear trap, but the evidencesuggests this trade will provide satisfaction, not injury. 1
  2. 2. The Real Returns Report Oct. 9, 2011VARIANT PERCEPTIONThe current generation of bond traders/ investors has never experienced Treasury yields at anywherenear 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 theFridson-Kong model), but instead the European sovereign debt crisis. For example, from Maythrough September, the correlation between daily returns of the BofA Merill Lynch U.S. High YieldMaster II Index and the CAC-40 stock index in Paris was 98%. Risk assets worldwide are nowmarching 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 neitherjunk bonds’ current fundamentals, nor even a dour forecast of their evolution warrants the riskpremium the market is now awarding them.THESISOn 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 andETFs have suffered massive outflows, driving the yield from 6.82% to 9.78% at Friday’s close (BofAMerrill Lynch High Yield Master II Index.) However, that change understates the increase in theyield spread as the flight to quality has driven Treasury bond yields to record lows. Consequently, thespread 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 currentlevel, the spread is roughly .8 standard deviations from its historical mean of 600 bps and wellwithin the top quintile of daily values dating back to the start of the 1997. Flare-ups in the Europeansovereign debt crisis look virtually inevitable, so there is every reason to believe the spread couldwiden over the short term, providing even better levels at which to put the trade on. Over the 2
  3. 3. The Real Returns Report Oct. 9, 2011medium/ long term, however, spreads this wide are highly unlikely to persist; mean reversion is areality in this market.In order to get some idea of the returns the trade might generate, the following table describes therecord of high-yield bonds’ outperformance with regard to equivalent duration Treasury notes over 3different 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 AverageSource: Aleph Advisors, BofA Merrill LynchThose numbers suggest the trade is already compelling, on an unleveraged basis, for investors whocan adopt a relatively long time horizon and are comfortable with some degree of volatility. The tradeis inappropriate for investors who are either highly leveraged (more than 1.5 or 2 to 1), or who cannottolerate some significant volatility in mark-to-market losses on a monthly or quarterly basis (in otherwords, 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 AverageSource: Aleph Advisors, BofA Merrill LynchWe believe it is worth initiating this trade now, and waiting patiently to fill out the positions as thecredit spread widens. 3
  4. 4. The Real Returns Report Oct. 9, 2011W HAT IF THE YIELD SPREAD DOESNT 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 followingsection. 4
  5. 5. The Real Returns Report Oct. 9, 2011APPENDIX: IS THE YIELD SPREAD MEAN-REVERTING?Although we aren’t systematic traders, this trade idea is partially predicated on the expectation thatthe high-yield spread will revert to the mean. We tested the monthly yield spread series forstationarity using the Augmented Dickey-Fuller test, with the following results: The monthly series of the BofA Merrill Lynch High Yield Master II Index option-adjustedH0 spread (OAS) is non-stationaryDF statistic (2.9418)p-value .1830Lag order 5Source: Aleph AdvisorsWith a p-value of .18, we can’t reject the null hypothesis that the yield spread is a non-stationary timeseries; however, 4:1 odds against isn’t bad, particularly when they’re bolstered by an economicrationale. We’re not testing random data series in the hope of finding mean reversion. We suspectthat the high-yield spread is mean-reverting because it is a shared property among other valuationindicators such as Shiller’s P/E10, which property is a manifestation of the fear/ greed pendulumthat animates investors. Incidentally, the same remarks apply to the yield spread series for the BofAMerrill Lynch Euro High Yield Index, which exhibits similar statistics: The monthly series of the BofA Merrill Lynch Euro High Yield option-adjusted spreadH0 (OAS) is non-stationaryDF statistic (2.8859)p-value .2063Lag order 5Source: Aleph AdvisorsWe 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 dueto the choice of the time period (the OAS data only goes back to December 1996.) Since 1997, we’veexperienced quite a few crises: The Asian crisis and LTCM, the bursting of the tech bubble, and themother of them all, the credit crisis. Perhaps this density of crises is distorting the distribution (onehas to be very careful with that type of argument; arguably, a ‘distortion’ that has a measurableimpact 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’sP/E10, which is one of the only reliable indicators of long-term value, indicates that U.S. stocks wereovervalued 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 tenyears.] This shows up when we run the Augmented Dickey-Fuller test on the monthly P/E10 series 5
  6. 6. The Real Returns Report Oct. 9, 2011over two different periods, the full history beginning in 1881 and the period December 1996 toSeptember 2011 (the sample period for the yield spread series: H0: The monthly series of the P/E10 is non-stationary Full History Last 15 YearsSample period 1881 – Sep. 2011 Dec. 1996 – Sep. 2011DF statistic (3.5648) (2.7917)p-value .0036 .2457Lag order 11 5Source: Aleph Advisors, Robert ShillerWhen 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-seriesthat 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 accurateor complete, and it should not be relied on as such.This research does not constitute a personal recommendation or take into account the particular investmentobjectives, financial situations, or needs of individual clients. Clients should consider whether any advice orrecommendation in this research is suitable for their particular circumstances and, if appropriate, seek professionaladvice, including tax advice. The price and value of the investments referred to in this research and the income fromthem may fluctuate. Past performance is not a guide to future performance, future returns are not guaranteed, and aloss of original capital may occur. Certain transactions, including those involving futures, options, and otherderivatives, give rise to substantial risk and are not suitable for all investors. 6