Editor’s Note: Sorry for taking so long to getting this post published. But as I’m not a strategist on a rates desk or a macro strategist (if only… *sigh*) and I have a day job along with other obligations, I felt it better to take my time and get this right than just rush something out there for the sake of getting it out there. On a related note, this shouldn’t be construed as investment advice by any stretch. Far from it. If you need that sort of service, there’s plenty of people to talk to about it. Just not me.
In a recent post, I talked about the risks inherent in a “bear flattener”. The risks aren’t trivial, especially given its shape and the levels we’re at currently. I posted on that as well, which you can find here. In it, I mentioned “a 25 or 50bp move will hurt more when your rates are near zero than it will when your rates are at say, 10 percent. It’s a law of large numbers effect.” The issue is one of rate volatility, especially at the short end of the yield curve. In the fixed income space, it’s called convexity and I’ll discuss it more later.
So the question is then, how do you play this? How do you trade it? If you wanted to do a straight bear flattener trade, you’d go long the TLT ETF (chart) which tracks the returns of and short the SHY ETF (chart) or the IEI ETF (chart). You could also blend the short position, because as the chart of Greek govies shows (seems like ages ago due to the “successful” 10 yr issue), the area between 1yr and 5yrs on the curve can be particularly violent in a bear flattener. So blending the short position probably makes sense.
But I’m not looking to put a bear flattener on as a directional trade, because there are a couple of scenarios that could unfold which would keep a normal, upward-sloping yield curve intact. What I’m concerned about is a shock to the carry trade I have on. If I had more conviction, I’d try to leg into this trade and re-adjust my lending and funding book positions to take advantage of the bear flattening’s occurrence – which means changing the duration profile of the whole book.
But for hedging purposes, I’m willing to give up spread to buy some insurance at a reasonable cost. If it costs too much, I won’t do it. But since the ETFs I talked about above may not match my funding book’s duration profile, I’m not going to be inclined to use an ETF-based strategy. I’ll explain what/how I will execute my hedge in a bit. Just keep reading.
Shape Of The Curve
For this post, I want to create a different example – but one that’s more realistic. Because if I’m going to talk about hedging, I don’t want to base it on something that’s pie in the sky. So I created a synthetic yield curve based on LIBOR rates. At the short end, I used Eurodollar deposits and the long end is based on the swap curve, which is just pricing 3 month LIBOR money at various durations. So it should be a reasonable proxy for a yield curve. The t0 rates are actual rates as of February 10, represented by the blue line. The red line is the hypothetical yield curve. This hypothetical is what I want to hedge against:
My fictitious funding book has a weighted average maturity of less than a year (0.7 years ~ 8.4 months), so I have to roll/refinance it 28 times to match the weighted average maturity of the investing/lending book I developed. To maintain the P&L I calculated at t0, I need to ensure the spread will stay that way for the life of the trade. But 28 rolls? At the same spread? I don’t think the odds are in my favor. Yes, I know I can liquidate the book, since it’s liquid, but I’d rather not get caught fleeing for the exits of a crowded movie theater where the attendant just yelled ‘FIRE!!’ I’d rather have a strategy in place that will let me withstand such a stampede. That requires developing a hedging strategy.
The hedging strategy is called “selling the curve.” That means I’ll want to sell off the front-end of the curve and purchase the long-end:
Since I know what the shape of the curve is that I want to hedge (it would also help if I had an idea as to what would drive the yield curve to be shaped this way), I need to: 1) Set a limit/risk tolerance – how much volatility do I want to hedge versus how much volatility can I live with. 2) How long do I want to put this hedge on? If it’s a very short timeframe, the costs may not be worth it to do the hedge. So with these things in mind, let’s think through how to construct our hedge.
Here, at these rates, my risk tolerance is pretty low, and here’s why: the law of large numbers. If rates were higher, I’d be less concerned about small basis point changes. But since rates are so low, small basis point changes can have big effects on the value of assets. I know I’ve said this before, but I just can’t emphasize this point enough.
Consider this chart from the CME Group regarding duration, which measures the relationship between a security’s price and its yield. I wrote some notes on the graph, that should explain things a little bit:
Hopefully my notes make sense. As you can see, price and yield are not linear. The law of large numbers I refer to is actually called convexity in bond-land and it refers to how fast duration changes for a security – it’s a second order effect. So I’m looking to hedge against the effects of both duration and convexity. Because as the graph shows, the effects are exaggerated at low rates.
So my hedging strategy will be to insulate my 3mth, 6mth, and 1yr positions. But my investing/long book is not as big of a concern. Price appreciation on the long end of the curve will allow me to lighten that position up by taking profits immediately and will also allow me to free up cash to develop a new portfolio with risk/return characteristics that suit me.
How Long to Hedge?
Frankly, I want to give this about 12-18 months to play out. I don’t want to hedge for too long, because rates can change and I might want to take the hedge off. Shorter-dated hedges are easier to sell (more liquid) than longer-dated ones. Also, I don’t want to build a hedge book that goes out 3, 4, or 5 years for cost reasons. I like to make money, but I’m not made of it.
Tools of the Trade
So what should be done? The most obvious hedging tools in this space are futures and options, and the CME has a pretty good suite of both. But since I like the flexibility of options, I used options on Eurodollar futures as my hedging tool of choice. But the use of Eurodollar based instruments makes sense for a number of reasons. First, my funding and lending positions are based on LIBOR rates, so Eurodollar hedges virtually eliminate basis risk between the investing book and the hedging book. Second, Eurodollar futures are pretty straightforward to understand. The interest rate is quoted in IMM Index points, which is expressed as 100 – the interest rate (on an annual basis). So as rates rise, the IMM goes lower. As rates fall, the IMM value increases.
So let’s put everything together. Options on Eurodollars are my hedging instrument, my tolerance to rate increases will be pretty low due to duration and convexity at these yields, and I want to look at making sure my book is completely hedged for a year. So that means I’ll need to hedge the 3mth portion of my funding book (4 rolls = 4 hedges), the 6mth portion (2 rolls), and my 1yr funding. So to sell the front end of the curve in my bear flattening scenario, I’m buying puts that give me the option to sell Eurodollar futures at rising rates as you go further into the future. I put a document on Scribd that outlines everything in this example, which you can see below. The hedging portion is on page 4, which is the most important/relevant piece for this post. Note that my approach is still relatively cheap. 57 grand to give my $100MM funding book some insurance against rising rates is pretty cheap:
Now I should explain the reason I highlighted some items on the last page, which outlines my hedging book strategy. You’ll see my longer dated 3mth hedges are rising in price rather swiftly. And the 6mth hedge at March-11 is much higher than my Sept-10 options. I highlighted them because I may not want to purchase them just yet. Or I may want to roll the strikes up or down, depending on open interest levels and pricing. In this scenario, I’m inclined to keep the strikes on my puts lower than the strikes where there’s significant open interest. Because I’ll want to move ahead of big surges so that I may also give myself an extra ‘out’ by selling the puts if I want to. But that depends on the rate/credit environment we’ll be dealing with in the future.
The rise in prices and costs during those highlighted areas is also an indication that there is some crowd of some size that may be looking to enter into a similar trade as me and they could believe a bear flattener and rising interest rates are in the cards for the future. But the decision to purchase at those time frames is still one I may hold off on, again depending on my view of rates, credit, and the economy in general. Also, I’m going to be interested in other folks’ views who are pursuing a similar strategy. Because that may give me some information to use in my strategy as well.
In the End
But at the end of the day, the decision to hedge or not is a personal choice. The way I outlined my hedging approach here isn’t the only way to play this scenario. There are other trades you can put on a hedge, other ways to deal with interest rate risk. Maybe I’ll cover them in the future sometime.
I also need to give a huge hat tip to the CME Group. Their site has tons of documentation, and a good deal of data as well. I wasn’t all that familiar with the practical aspects of making these trades work, and I never really considered myself much of a futures user/trader so this has been a little bit of a learning experience for me. Hopefully my logic and tactical implementation make sense, but at any rate, this was a very interesting exercise.
Enjoy, dear reader(s??)