Bond Hedging

The market-neutral equity manager buys "attractive" stocks and sells short "unattractive" stocks, trying to take away the effect of broad market moves. The bond hedger buys attractive bonds and sells short unattractive bonds, also trying to remove the effect of broad market moves. The attractive bonds usually have a higher yield than the unattractive bonds, so there is a yield spread between the long portfolio and the short portfolio. If a high-quality corporate bond offers a yield of 6.0 percent while a Treasury of comparable maturity offers a yield of 5.8 percent, then the corporate bond offers a spread of 0.2 percent. If the bond hedger thinks that this is an attractive spread, then he will try to capture the spread by buying the corporate bond while shorting the Treasury.

We emphasized in Chapter 9 that hedging is not an infallible recipe for reducing risk. A hedged position is a bet that the long position will outperform the short position. In the world of bonds, if one bond performs better than another bond, then the yield spread between the two bonds narrows. To see this, suppose that a hedge fund manager has a long position in bond L and a short position in bond S. We assume that the yield on bond L is greater than the yield on bond S, so the hedged position captures a positive spread between the two bonds. If bond L performs better than bond S, then it may be that the price of L goes up while the price of S stays the same. But if the price of L goes up, then the yield of bond L will go down, and so the yield spread between the two bonds will narrow. Alternatively, it may be that L does better than S because the price of L remains constant while the price of S goes down. But if the price of S goes down, then the yield of bond S will go up, and so once again the yield spread between the two bonds will narrow.

Generally speaking, yield is an indicator of risk: If one bond has a higher yield than another, it is prudent to assume that the first bond has more risk than the second. Thus the basic position of the bond hedger is to own the higher-risk bond while taking a short position in the lower-risk bond. This means that bond hedging is far from riskless. In addition, yield spreads are often very small, typically less than 1 percent. So the bond hedger often applies large amounts of leverage in order to deliver the returns that he is after. Long Term Capital Management was a highly leveraged bond hedging operation whose spectacular failure is a vivid illustration of what can go wrong in bond hedging.

There are many different kinds of risk that can explain yield spreads. The four most common risks are inflation, credit, prepayment, and liquidity. Let's have a closer look at each of these risks.

U.S. Treasury obligations are a good example of inflation risk without credit risk. Credit risk is the risk of default: The borrower fails to repay the debt. In the case of a U.S. Treasury obligation, there is essentially no risk of default. After all, the government has the ability, in extreme circumstances, simply to print the number of dollars required to repay the debt. But this moves the spotlight to inflation risk. If you buy a $10,000 Treasury bond today that matures in 10 years, you can be certain that you will receive $10,000 in 10 years. But how much will $10,000 be worth in 10 years? What will you be able to buy for $10,000 in 10 years? The answer to this question depends on the level of inflation over the next 10 years. (Several years ago the U.S. Treasury began to issue special bonds whose interest payments and final maturity payment adjust to take into account the effect of inflation. These bonds solve the bond investor's main worry, inflation, but they have other complexities that have slowed their acceptance by the marketplace.)

When investors lend money for 10 years, their first worry is what the real value of a dollar will be in 10 years. When investors are worried about the possibility of rising inflation, they demand a high interest rate to compensate for the inflation risk. When investors are more optimistic about the outlook for inflation, they are willing to accept lower interest rates. The spread between long-term rates and short-term rates is thus a symptom of the level of anxiety surrounding the likely course of inflation. A wide spread means high inflation anxiety; a narrow spread means low anxiety. Figure 17-2 shows the history since 1990. Notice the very wide spreads that prevailed in the early 1990s and again in 2001. Both periods were periods of slow growth or recession in which the Federal Reserve was easing monetary policy aggressively.

Corporate bonds have inflation risk and credit risk. Credit risk is the risk of default, that is, the risk of not getting paid at all. Even very high quality companies sometimes default on their debt. And with lower-quality companies, the companies that issue high-yield debt, the risk of default is a major issue. When investors think that the risk

FIGURE 17-2

Inflation Versus Yield Spreads

January 1990 through December 2001

FIGURE 17-2

Inflation Versus Yield Spreads

January 1990 through December 2001

The yield of the U.S. 10-year Treasury bond less the yield of the U.S. Treasury bill. Analysis based on monthly data, January 1990 through December 2001. Source: Bloomberg LP.

of default is high, they will demand a very high yield on the money that they lend. When investors think that the risk of default is low, they will accept a lower yield. Figure 17-3 shows the history of yield spreads for both investment-grade bonds and high-yield bonds. Notice that yield spreads came in steadily from late 1990 until mid-1998 as investors grew more and more confident about the economy, then widened in the last few years as the economy weakened and investors perceived more risk in corporate bonds.

Prepayment risk is the risk that the loan will be repaid at a time when interest rates are lower, which creates the problem of reinvesting the funds in a lower-rate environment. Bonds backed by home mortgages provide the main example of prepayment risk. The main issuers are the Government National Mortgage Association (Ginnie Mae or GNMA), the Federal National Mortgage Association (Fannie Mae or FNMA), and the Federal Home Loan Mortgage Corporation (Freddie Mac or FHLMC). When a homeowner borrows money for 30 years to buy a house, she has the right to pay back the loan before the 30 years are up. This can be done without a prepayment penalty. If interest rates go down after the homeowner takes out a mortgage, the homeowner will be able to refinance the mortgage at the lower rates. The homeowner borrows money at the

Relative-Value Investing FIGURE 17-3

Corporates and High Yield Less U.S. 10-Year Treasury Bonds

Monthly Yield Spreads, January 1990 through December 2001

Corporates and High Yield Less U.S. 10-Year Treasury Bonds

Monthly Yield Spreads, January 1990 through December 2001

Calculations based on yields for the Merrill Lynch U.S. Corporate Master Index, Merrill Lynch U.S. High Yield Master II Index, and 10-year U.S. Treasury bonds. Source: Merrill Lynch and Bloomberg LP.

low rates that now prevail and uses that money to pay off the higher-rate mortgage.

When a homeowner refinances a mortgage, the homeowner is buying back the original mortgage at face value. When interest rates go down, the value of the mortgage bond should go up, but this appreciation is limited by the fact that the homeowner holds a call option that enables her to buy back the mortgage at face value. The yield spread that separates mortgage-backed bonds from Treasury bonds is the price of the call option that the mortgage lender has granted the homeowner. Figure 17-4 shows the changing spread between mortgage-backed bonds and Treasury bonds.

The final risk is liquidity. Liquid bonds are bonds that are available in size, have a large daily trading volume, and command a great deal of investor attention. Illiquid bonds are smaller, they trade less, and they are not as close to the center of attention. Other things being equal, more liquid bonds will have higher prices, and lower yields, than less liquid bonds. For example, consider the difference between on-the-run Treasuries and off-the-run Treasuries. The U.S. Treasury issued a 30-year Treasury bond every quarter. The bond that was

FIGURE 17-4

Mortgage-Backed Bonds Less 10-Year Treasury Bonds

Monthly Yield Spread, January 1990 through December 2001

FIGURE 17-4

Mortgage-Backed Bonds Less 10-Year Treasury Bonds

Monthly Yield Spread, January 1990 through December 2001

Calculations based on yields for the Merrill Lynch GNMA Master Index and 10-Year U.S. Treasury bond. Source: Merrill Lynch and Bloomberg LP.

issued at the most recent auction is the on-the-run 30-year Treasury. The bonds that were issued at earlier auctions are the off-the-run Treasuries. The on-the-run Treasuries are consistently more liquid than the off-the-run Treasuries, and usually they trade at a slightly lower yield than the off-the-run Treasuries, even though the maturities are essentially the same.

So we have at least four different kinds of risk that can produce yield spreads attractive to bond hedgers: inflation risk, credit risk, prepayment risk, and liquidity risk. Now let's take a quick look at how to capture those spreads and what risks arise in the process.

Let's begin with the simplest case. Suppose that long-term interest rates are 6 percent, money can be invested short term at 3 percent, and money can be borrowed short term at 3.5 percent. If you buy long-term debt at a yield of 6 percent, and finance the purchase at a cost of 3.5 percent, then you are earning a positive spread of 2.5 percent. This is a positive carry trade: The yield on the long position is greater than the cost of financing the position. If you lever the trade 2:1, then the net yield (the yield on the full long position less the cost of financing) is 8.5 percent. If you lever the trade 5:1, then the yield goes up to 16 percent. Every unit of leverage adds 2.5 percent to the yield of the total position.

Does this mean that you should borrow a lot of money at 3.5 percent in order to buy bonds yielding 6 percent? Absolutely not. This trade has immense risk. If interest rates go up, then the cost of financing goes up, the price of the long position goes down, and you are in a position to lose real money. Consider the price and the yield of a 10-year bond. Prices go up as yields go down, and vice versa. Figure 17-5 shows the price and the yield of the 10-year bond that was issued in August 1999 and matures in August 2009. As the yield declined from 6.8 to 4.1 percent, the price increased from 94.50 to 112.88. In other words, a yield change of 2.7 percent translated into a 19 percent increase in the price of the bond.

But this works in the other direction too. In late 2001, the price dropped 7 points as the yield increased by 1 percent. In other words, an adverse price move is more than enough to wipe out the yield advantage of the longer-term bond. Moreover, the yield advantage will be earned over the course of a full year. For example, a 3.5 percent yield spread works out to about 0.3 percent per month. Price moves of that size are a dime a dozen. One bad day, or week, can destroy the yield advantage you were counting on for the entire year.

FIGURE 17-5

Daily Price and Yield of a 10-Year U.S. Treasury Bond

January 3, 2000 through December 31, 2001

FIGURE 17-5

Daily Price and Yield of a 10-Year U.S. Treasury Bond

January 3, 2000 through December 31, 2001

Analysis based on daily pricing and yield information for U.S. Treasury 10-year bond 6 percent yield, matures August 15,

2009.

Source: Bloomberg LP.

Analysis based on daily pricing and yield information for U.S. Treasury 10-year bond 6 percent yield, matures August 15,

2009.

Source: Bloomberg LP.

The trade we have just described is the classic borrow short-lend long position. This trade has wreaked havoc on banks, savings and loan (S&L) associations, and other lending institutions. An S&L borrows from its depositors and lends to homeowners. The S&L holds a portfolio of long-term mortgages, so the assets of the bank have a long maturity. But the bank deposits are a short-term liability. If interest rates go up, the S&L faces rising financing costs and falling asset values. Thanks to the S&L crisis of the late 1980s, lending institutions are generally much more careful in matching the maturity of their assets and their liabilities.

Because of these risks, the bond hedger is not likely to set up the simple borrow short-lend long trade. She may introduce various hedges to protect against falling asset values or rising financing costs. But all these protective measures will have a cost. The question at the end of the day is whether there is any return left after the relevant risks have been hedged away.

Figure 17-6 shows the background for hedging credit risk. The yield spread is the difference between high-quality corporate bond yields and government bond yields. The return spread is the monthly return of corporate bonds less the return of government bonds. If

FIGURE 17-6

Corporate Bonds Less 10-Year Treasury Bonds

Monthly Yield and Price Spreads, January 1990 through December 2001

FIGURE 17-6

Corporate Bonds Less 10-Year Treasury Bonds

Monthly Yield and Price Spreads, January 1990 through December 2001

Calculations based on yields and monthly total rates of returns for the Merrill Lynch U.S. Corporate Master Index and Merrill Lynch U.S. Treasury Master Index. Source: Merrill Lynch.

you're long corporates and short governments, you are betting that corporates will outperform governments, so you want the return spread to be positive. As the yield spread narrowed from early 1993 through late 1997, corporates generally outperformed governments. As the yield spread began to widen in early 1998, you begin to see months when corporates lag Treasuries by 1 percent or more. Yet the object of the hedge was to capture an annual yield spread of about 2 percent, which works out to about 0.15 percent per month. Again, one bad month of price action can destroy the yield advantage that was available over the course of a full year.

Figure 17-7 makes the same point with high-yield bonds against government bonds. As the yield spread widened from 4 to 8 percent, there are several mont hs during which the long-high-yield/short-government "hedge" will lose 4 percent or more. One bad month wipes out the yield a dvantage that you were counting on for the whole year.

The bond hedger's basic strategy is to identify a wide spread, put on a hedge designed to capture that spread, and then apply a large amount of leverage to make the total return interesting. But this is simply the classic strategy of reaching for yield, with leverage added in to boost return, and risk. And that is a short volatility trade.

FIGURE 17-7

High-Yield Bonds Less 10-Year Treasury Bonds

Monthly Yield and Price Spre ads, January 1990 through

December 2001

High-Yield Bonds Less 10-Year Treasury Bonds

Monthly Yield and Price Spre ads, January 1990 through

December 2001

Calculations based on yields and monthly total rates of returns for the Merrill Lynch U.S. High Yield Master II Index and Merrill Lynch U.S. Treasury Master Index. Source: Merrill Lynch.

The potential gain in the hedged position is finite, since the normal expectation is that the spread will return to its average level. In the extreme case, the spread might go to zero, or even turn slightly negative (in which case bond investors will say that the high-risk instrument is trading through the lower-risk instrument), but these scenarios are very unlikely. So the bond hedger seeks the high probability of earning a finite incremental yield, and must deal with the small probability of a large loss. The loss is large because liberal amounts of leverage are required to deliver the very small yield spread in a dosage that investors are likely to be interested in. Some of the most conspicuous blowups in the hedge fund world have been in the area of bond hedging since the required level of leverage may turn out to be fatal.

These cautionary notes are not meant to scare you away from bond hedging altogether. There are managers who are very sensitive to the risks involved and have displayed an ability to manage those risks intelligently. But this is an area that requires unusual levels of caution. When you're picking up nickels in front of a bulldozer, never take your eyes off the bulldozer.

Lessons From The Intelligent Investor

Lessons From The Intelligent Investor

If you're like a lot of people watching the recession unfold, you have likely started to look at your finances under a microscope. Perhaps you have started saving the annual savings rate by people has started to recover a bit.

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