What is a Basis Point Worth?
Ten years ago I started working in Japan as a fixed income sales-trader for an international investment bank. I was frequently called upon to travel to other parts of Asia such as Beijing, Hong Kong, Seoul, Singapore and Sydney. My mandate was to invite clients to explore the many money making opportunities available to them by trading the (G4) U.S., German, U.K. or Japanese yield curve. The touchstone recommendation always seemed to be some combination of going long or short U.S Treasuries and establishing an offsetting position in like maturity German Bunds. Most of our trade ideas were simple variations of a basic mean reversion strategy - optimistic to pick up a few basis points along the way.
After my pitch, I was frequently met by the same incredulous reaction, "Eddie, we are not interested in making a few basis points....we want full points, preferably in multiples of 10." No one wanted to inconvenience themselves and stoop down and try to pick up 10, 20 or even 50 basis points! Of course being in Asia, the clients were always very professional and extremely polite, but my colleagues and I usually left empty handed. We did not win a lot of new business out there.
Back then 10y yields ranged between 4.25% and 5.25% in the U.S., U.K. and Germany and about 1.75% in Japan - so maybe some investors could afford to ignore a few basis points here and there. Well, we have all moved on since 2004 and 10y yields now range between just 0.53% in Japan and 2.72% in the U.K. with the U.S. and German yields sandwiched in the middle. Today's investors are less finicky and are now falling over themselves to collect those very same basis points.
So what do you do when you are now faced with a diminutive and none too generous yield curve- and you need income? Here are some (very risky) strategies:
-
Sell a Tail - increase leverage and borrow on margin; borrowing money to increase long exposure is effectively selling the left tail in a distribution of potential outcomes
-
Sell Volatility - sell options outright and or engage in covered call writing
-
Sell Convexity - or go long instruments like MBS or callable bonds
-
Sell Quality - that is go long lower rated, more risky instruments like High Yield
-
Sell Liquidity - that is buy highly illiquid instruments like Emerging Market debt denominated in local currency
-
Buy Structured Products - that is doing all of the above in one handy trade
The concern, in my view, is that all these alternatives are now almost completely exhausted. Look at a table of Bond Benchmark Performance you will see that just about every index is near its 52 week low in spread. That means you don't get many basis points (forget about full points!) by engaging in the highly risky strategies numbered above. As an asset class, risky bonds, look well...very risky. The upside is measured in basis points, while down side is measured in points.
An Oligopoly in Government Bonds
-
They maximize profits - or in our case, they strive to reduce debt service costs
-
They are price setters - The FED, ECB, BOE and BOJ take care of that
-
No price competition - they compete on perceived "safety" and "coercion", not price
-
High barriers to entry - think of all the problems faced by BITCOIN
-
Earn abnormally high profits - the low returns investors are forced to accept are the mirror image of high deficits governments are permitted to run
-
Perfect Knowledge - The issuers are always right simply because there is no cost of failure; the debtor never gets hurt, all the pain is absorbed by the creditors
If you, like me believe that the above is a fair description of today's G4 government bond markets, then where do you think yields are heading? Lower, probably. From an asset allocation standpoint, government bonds are a necessary component to reduce overall portfolio volatility, but more importantly, to act as an at the money option against a big left tailed event. Back in 2008 the S&P 500 lost 38.47%. The typical 60-40 portfolio would have been down 21% if the fixed income portion, i.e. the 40%, was invested in Barclays Aggregate Bond Index, which of course includes risky bonds like corporates and mortgages. If the same portfolio used its 40% allocation to fixed income to simply purchase U.S. 10y Notes rather than the BarCap Index, the overall portfolio would have suffered just a 14.9% drop.
What did the option cost back in 2008? Broadly you gave up about 1% to make 6% or a 1:6 ratio. That is pretty good. Today, the same option would cost about 0.40% - yes much, much cheaper than at the beginning of 2008! How do I get these numbers? I assume the option premium is the spread you give up when buying U.S. Treasuries rather than the purchasing broad bond market index. Today that spread is just 40 bp. The payoff is the degree of outperformance enjoyed by owning Treasuries instead of the index during a crisis (about 15%) weighted by the portion of the portfolio allocated to fixed income (40%) or .15 * .40 or about 6%.
It makes absolutely no sense of holding a board bond index here at a paltry spread over Treasuries of just 40bp, when you can own the Treasury that provides a huge amount of insurance against an unanticipated shock.
India, Worth a Shot?
I know absolutely nothing about investment prospects on the Indian subcontinent. I do know that India does have a new government headed by the supposedly market friendly Prime Minister Narendra Modi. I also know that the famed economist Gary Shilling and Mr. James Grant, he of the must read Grant's Interest Rate Observer, are both bullish on India. I respect and often follow the advice of market experts but I always insist on checking some numbers myself. It's a good habit. So I found some basic exchange rate arithmetic handily provided by both the IMF and the Economist Intelligence Unit to support the investment case for India. Their calculations indicate the Indian Rupee is undervalued in real terms by anywhere from approximately 40% to 70%! Now I will be the first to admit that ability to predict exchange rate corrections based upon real exchange rates is less than stellar - in fact it's pretty awful. Nonetheless, with India, you are getting a good margin of safety on the currency (similar to China), a Government that is at least rhetorically pro-business and young and a well educated population that is clamoring for change. The more popular India focused country ETFs are all up between 25%-35% during the past year but are flat to slightly down over the past 3 years. Essentially, you could have anticipated the improved investment climate in India three years ago and still made no money. Who said investing was easy?
Edward Talisse
© 2014. Chelsea Global Advisors. All Rights Reserved
The author is solely responsible for the content of this mail- not any current or former organization or employer that the author belongs to. Any content posted in this mail or on the website is solely intended to provide general information, observations and ideas rather than specific advice. All the views here are solely the expression and opinions and personal experiences of the writer. This mail and the website are updated regularly and any information contained herein should be considered dynamic rather than static. Hence the content changes over time as the topics change. The information published herein might not be valid or accurate two weeks or two years from now. Content, sources, information and links change over time, and therefore, the writer makes no claims of accuracy of such information as the mails and website and its content evolves over time.
