Julian Robertson's Steepener Swap Play (Shorting US Treasuries) ~ market folly

Wednesday, June 3, 2009

Julian Robertson's Steepener Swap Play (Shorting US Treasuries)

Simply put, Julian Robertson is the definition of a hedge fund legend. And, his success is noted by the fortune he has amassed as he now graces the Forbes' billionaire list. He has pioneered a successful investment methodology, he has generated outstanding returns at his famous hedge fund Tiger Management, and his influence has sprouted some of the most successful modern day hedge funds in the form of the 'Tiger Cubs.' And, most importantly, he predicted the financial crisis two and a half years ago in an interview with Value Investor Insight. When he talks, you listen.

For those unfamiliar with Robertson, we'd highly recommend checking out the profile/biography we just wrote on him this morning. In that piece, we have outlined exactly why you should follow him (and the Tiger Cubs for that matter too). As we detailed in his profile, Robertson has a unique investment methodology. He takes a macro approach, finds a smart idea, researches it exhaustively, and places a big bet. And, when he feels he is more than correct, he will 'bet the farm.' And, it looks like we have identified Robertson's next play where he has and will continue to 'bet the farm.'

Julian's Big Bet

Let's start by making one thing clear: this is not a new position for Robertson. He has been talking about different forms of this play for a while now. But, since he has so much conviction behind this bet, we figured it would be prudent to take a closer look. Not to mention, his interview with Value Investor Insight was just published and it again highlighted his thoughts on this play. Today, we are going to highlight Julian Robertson's steepener swap play. In layman's terms, he is betting on inflation. Taken from eFinancialNews, "Steepeners are a type of interest rate swap, where one party agrees to pay the other a fixed rate in exchange for a floating rate, which is derived from the difference between long and short term rates. Many of these products also use high leverage, where the difference between the two rates is multiplied by up to 50 times to produce a higher return."

He thinks rates could hit 7% easily and could go as high as 18%. We agree with him on this play and we first published our very basic rationale behind shorting US Treasuries back in October of last year. The main point we're focused on is the wager that inflation is in our future. If such an outcome came to fruition, yields on long-term Treasuries would rise. When the yields increase, bond prices will drop, thus benefiting the short position. While the vehicles noted in this article are all slightly different in construction and purpose, they all broadly wager on the same outcome: inflation. Julian's talked about this play in numerous forms, and we actually first heard about his 'curve steepener' play in January 2008 in Forbes. That piece highlighted how Robertson was "long the price of two-year Treasuries and short the price of the ten-year Treasury - betting that the difference, or curve, in the yield between the two will increase." Such a play is negative on the US economy and Robertson executed it because he felt the Federal Reserve would continue to flood the economy with money. And, he has been right.

What's fascinating here is that retail traders and investors could put on essentially the same play using the marvels of exchange traded funds. If you wanted to put a curve steepener play on by going long the 2 year Treasuries and shorting the 10 year Treasuries, you could simply buy SHY (iShares Barclays 1-3 year Treasury etf) and then short IEH (iShares Barclays 7-10 year Treasury etf). This is an easy way to put on the same trade Julian played at the beginning of 2008.

Robertson ultimately feels that the US dollar will become so weak that it causes the central banks of China and Japan to stop purchasing Treasuries. As such, 10-year bond prices would move down and that's exactly what we've seen play out. Back in January of 2008, Robertson told Fortune, "I've made a big bet on it. I really think I'm going to make 20 or 30 times on my money." Moving on from his curve steepener play, we then heard Julian talk about a 'steepener swap' play at a Tiger Cub hedge fund panel. At the panel, Robertson joked that last Christmas his family would have “a steepener in every stocking." This is definitely one of Robertson's token 'bet the farm' plays if there ever was one.

In his recent interview with Value Investor Insight, Robertson lays out further rationale for his play. He says, "I'm amazed at the amount of money the government is throwing at this thing. You don't even react anymore unless somebody's talking about $1 trillion. I genuinely admire the administration's courage in doing what it's doing, but not the wisdom of it. I look at the TALF (Term Asset-Backed Securities Loan Facility) program, for example, and it's almost a bribe to get people to put on more leverage ... I ask anyone to give me an example of an economy beefed up by huge amounts of quantitative easing that did not inflate tremendously when or if the economy improved. I think what we're doing now will either fail, or it will result in unbelievably high inflation - and tragically, maybe both. That would mean a depression and explosive inflation, which is frightening."

While it may be frightening, it seems to be the scenario that Robertson is wagering on. After all, his steepener swap play will shower him with profits if rampant inflation rears its ugly head. He thinks that the US has not solved the current problems and things could go from bad to really bad. He likened the U.S.'s current situation to that of Japan in 1989, but thinks we are in far worse shape.

Notable Investors Bearish on US Treasuries

Robertson is most certainly not alone in his views. Numerous other prominent investors and hedge fund legends share his distaste for treasuries. We just recently noted that Michael Steinhardt says treasuries are a foolish play over the long term. He categorizes them as risky, noting that the yields are low and the danger is high. Steinhardt of course ran one of the first truly successful hedge funds (Steinhardt Management), garnering a 23% return each year for almost thirty years.

Additionally, acclaimed investor Jim Rogers also wants to short government bonds. Rogers is well-known for his stellar returns while managing the Quantum Fund (now defunct) with then partner George Soros. Rogers expects the government to buy Treasuries in an effort to stem borrowing costs. Rogers says that since Governments around the world are printing a ton of money and borrowing insane amounts that he almost has no choice but to short them. Rogers had previously been short the Treasuries, but covered them for the near-term in favor of waiting for another opportunity to short, as we noted when reviewing Rogers' portfolio. We could add even more talented investing names to this list, but suffice it to say that there is a confluence of smart minds all marching to the same beat.

When such a confluence of smart minds all wager on essentially the same thing (inflation), you should probably turn your head at the very least.

How To Play It

Now that we've seen so many smart minds interested in this wager, how do we play it? There are essentially a few different ways to place a bet on inflation similar to that which Robertson has made. The vehicles referenced earlier are not typically available to retail investors and traders. As such, we'll focus on ways that non-institutional players can protect themselves from inflation. Additionally, we'll take a quick look at the complex vehicles for those working at institutions with access to such products.

Exchange Traded Funds (ETFs) / Mutual Funds

The simplest way for retail investors and traders to bet on inflation is to bet against US treasuries by shorting them. Currently, there are a few ways you can do this. There are two exchange traded funds (ETFs) currently offered which index long-term treasury bonds. Ticker TLT is the iShares Barclays 20+ year treasury fund. Its performance corresponds to the price and yield of the long-term treasury market. As such, investors and traders who wish to bet on inflation (and against treasuries) can simply short TLT. Also, those who wish to play the 7-10 year Treasuries can do so via iShares Barclays Treasury index etf IEF. That vehicle corresponds to the price and yield performance of the intermediate term sector of Treasuries.

Additionally, you could also buy put options (LEAPs) on this index if you were so inclined. Buying puts on TLT is essentially the same bet as shorting TLT outright. We are not necessarily recommending using options to execute this play because of the leverage they employ, the time decay that moves against you, and the fact that we're not big fans of LEAPs to begin with. And, let's face it, such a large bet on inflation could take years to play out. As such, you're pretty much forced to use LEAPs if you wish to execute this play via options.

There is also another exchange traded fund currently out that 'ultrashorts' the treasury market. Its ticker is TBT and it is 2x the inverse of the TLT vehicle we just mentioned. However, there is one huge caveat with this play. Ultrashort ETFs reset on a daily basis and suffer compounding errors over time and noticeably more volatility. So, the longer you hold them, the more your results skew from the index they are supposed to be tracking. And, that is not something you want to experience when placing a longer-term bet on treasuries. Consider that over the past 1 year timeframe, TLT is up 1.43%. Theoretically, since TBT is 2x the inverse of TLT, TBT should be -2.86% over the same timeframe, right? Wrong. As you can see from the chart below, over the same time frame, TBT is actually -24.37% and has not tracked its index accurately over time at all whatsoever.

(click to enlarge)

This is why you should avoid using TBT for anything besides daily trades. There have been numerous articles published on this subject, and we recommend avoiding ultrashort ETFs. Additionally, since TBT employs leverage, it carries more risk. For the retail investor or trader, simply shorting TLT seems to be the best and easiest option at this point in time.

Investors also have the option of using the Rydex Inverse Government Bond Strategy mutual fund (RYJUX). This mutual fund has an expense ratio of 1.4% and essentially is the same as shorting TLT outright without leverage. RYJUX is a 1x short of 30-year Treasuries and is another option for investors who don't mind slightly less liquid mutual funds.

Lastly, while unrelated to the plays Julian Robertson has referenced, investors also have another option to protect themselves from inflation. Buying Treasury Inflation Protected Securities (TIPS) is an easy option that can be done via another exchange traded fund, TIP. This iShares Barclays etf is a bond fund that tracks the price and yield of the inflation-protected sector of the US Treasury market and is another vehicle that helps shield you.

Steepener Swaps / Constant Maturity Swap (CMS) Rate Cap

Now we'll turn our focus to the specific investment vehicle Julian has referenced. The vehicle is called a steepener swap and it is typically reserved for institutional investors.

In his recent interview with Value Investing Insight for May/June 2009, Julian Robertson says, "The insurance policy I would buy is called a CMS [Constant Maturity Swap] Rate Cap, which is the equivalent of buying puts on long-term Treasuries. If inflation happens the way it could, long-term Treasuries are just going to explode. Less than 30 years ago, long-term interest rates got to 20%. I can envision that seeming like a very low interest rate compared to what might occur in the future."

Option ARMageddon has also posted up a nice explanation of the vehicle courtesy of Tiger trader Pat O'Meara. They note that these are options to bet on interest rates rising for 10-year or 30-year treasuries. Option ARMageddon writes, "(Tiger trader Pat O'Meara) provides a current example, in which one could buy for $50,000 a five-year option, betting that the yield on $10 million worth of 10-year Treasuries rises above 4.2% between now and expiration in 2014. Including the 0.5% cost of the option, the break-even yield level is 4.7%." So, the vehicle is slightly more complex and definitely an institutional type of wager.

Other Inflationary Wagers

While Julian certainly thinks inflation is in our future, he is hesitant to buy gold. In the Value Investor Insight interview, he goes on to say that, "I've never been particularly comfortable with gold as an investment. Once it's discovered none of it is used up, to the point where they take it out of cadavers' mouths. It's less a supply/demand situation and more a psychological one - better a psychiatrist to invest in gold than me." While his argument makes sense, we found it intriguing seeing that we have tracked numerous prominent hedge fund managers moving into gold here on the blog.

Robertson's former colleague Stephen Mandel of Lone Pine Capital has a large call position on the Gold etf GLD. Additionally, respected hedge fund managers such as David Einhorn of Greenlight Capital, Eric Mindich of Eton Park Capital, and John Paulson of Paulson & Co all have sizable gold (and gold miner) positions. While Robertson doesn't like gold as an inflation play, he does have a few other recommendations. He likes natural resource stocks and then also says, "Zinc would also seem to me to be a very good inflation hedge."

Precautionary Note

While we have finally gotten around to writing a follow-up to our initial treasuries post, we do want to insert a note of caution. Year to date for 2009, treasuries are already down over 23%.

(click to enlarge)

The sudden and rapid decline is most likely due for a correction and we do not feel that the current time is ideal to initiate a position in shorting Treasuries. We would look for any sign of a rebound before putting on a new short position. That said, we still feel the move in treasuries will take many years to fully play out and this is a very long-term inflationary bet. While short-term moves like the one we've seen this year are nice, the full extent of the move could take years to come to fruition. We consider the publication of our post on this topic to be a contrarian indicator. After all, when there are headlines saying for you to get into something after a big move has already taken place, it's time to at least take some profits. So, place your bets with caution, as you'll have plenty of time before inflation truly rears its ugly head.

If you believe inflation is in our future, then 'bet the farm' with Robertson by buying steepener swaps, shorting US Treasuries, or buying puts on long-term Treasuries (whichever you have access to). As infomercials for rotisserie cookers like to enthusiastically exclaim, just 'set it and forget it.'

blog comments powered by Disqus