Julian Robertson Shifts From Curve Steepeners To Curve Caps ~ market folly

Friday, September 25, 2009

Julian Robertson Shifts From Curve Steepeners To Curve Caps

Yesterday on CNBC, the wizard of Wall Street and hedge fund legend Julian Robertson was on what seems to be his once-a-year CNBC appearance. The Tiger Management founder talked about inflation expectations and a theoretical scenario if China and Japan stopped purchasing US bonds. He also talked about some of his investment plays which we were interested to hear about. It's tough to track him since he generally likes to keep out of public's eye, but we have a prime opportunity to hear his investment ideas through our discount to the Value Investing Congress (discount code: N09MF3). Julian will join prominent hedge fund managers David Einhorn of Greenlight Capital, Bill Ackman of Pershing Square, Joel Greenblatt of Gotham Capital and many more to present actionable investment ideas at the 2-day event. If you want to learn from some of the best in hedge fund land like Julian Robertson, this event is a must-attend.

Julian's Updated Position

As we covered a long while ago, Julian Robertson's favorite play at the time was essentially an inflationary bet as he liked curve steepeners. Since then, he says he has refined his play and has turned to the curve cap. He says, "The curve steepener was a measurement of the differential between short and long term rates and we figured short term rates would go down and long term rates would go up. We didn't do well on the long term part, but the short term part worked out so well that actually we made a little money on the trade. Short term rates are nothing, so they can't really go below nothing. We've shifted the curve steepeners, which are basically long-term puts on long-term bonds... highly leveraged and they're like puts in that you know what your risk is, it's measured by what you paid for the put. I think (long term rates) can go to 15, 20 percent." He then also went on to focus on the economy and the situation we are presently in by saying, "I really do think the recession is at least temporarily over. But we haven't addressed so many of our problems and we are borrowing so much money that we can't possibly pay it back, unless the Chinese and Japanese buy our bonds."

Curve Steepeners Versus Curve Caps

Robertson had been in various forms of a curve steepener for a few years now and it appears that he keeps adjusting and tweaking the play as the market and economy shifts. We've heard about curve steepeners, steepener swaps, and now curve caps as well. We thought it would be prudent to quickly touch on these instruments for those less familiar with them as they are in fact highly leveraged institutional play. The closest thing we can compare them to is put options on long-term interest rates.

Let's start with the main focus of the curve steepener. 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." This seemed to have previously been the most commonly used play amongst hedge funds. However, as Robertson noted in his interview, this vehicle is less desirable now that short-term rates are at zero and can't really go below zero. As the market shifts, so does Robertson.

Seeing how he doesn't want to play the differential between the rates anymore, he has moved on to CMS rate caps, or curve caps. In an interview with Value Investing Insight back in their May/June 2009 edition, 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." As he says himself, the closest thing you can equate this play to is long-dated puts on long-term treasuries. However, the curve caps he is in are obviously more of an institutional play and are highly leveraged. The curve cap tries to capture the move in long-term rates whereas the steepener tries to capture a differential between short-term and long-term rates. For a more in-depth look at constant maturity swaps (CMS) we recommend reading the embedded document below from Eric Benhamou, a former Senior Quantitative Analyst for Goldman Sachs.

Swaps Cms Cmt

You can also download the .pdf here.

Placing the Bet

For the sake of 'looking out for the little guy,' we also wanted to briefly show how a retail investor can play it. This is by no means an identical way, but it's really as close as you can get as a retail player. We of course must preface this by saying to do so at your own risk because this is a slightly riskier and more speculative play that involves leverage (stock options) and falls outside the normal realm of just stocks and bonds. To replicate his play, one can buy puts on long-term treasury exchange traded funds (ETFs). The main vehicles in this realm are the iShares Barclays 20+ Yr Treasury (TLT) for the 20 year bonds, the iShares Barclays 10-20 Yr Treasury Bond (TLH) for the 10-20 year spectrum, or the iShares Barclays 7-10 year Treasury (IEF) for the 10 year bonds. So, which bond you play is up to your discretion. For the purpose of our example, we'll use the 20+ year treasury, TLT.

To execute the play, you then have to buy puts on the exchange traded fund. The key here is to buy long-dated puts, or options that won't hit expiration for quite some time, in order to most accurately replicate Julian's play. By using options, there are both risks and benefits involved. Firstly, there is the risk of leverage as each put is representative of 100 underlying shares of TLT. Secondly, since you would be using options, you have to be wary of time decay, as this works against you with each day that passes. However, the good thing about using puts is you can limit your downside risk. The absolute most you can lose on the trade is the value of the put you purchase. This is in contrast to a short common stock position where you can technically lose an infinite amount.

Having identified the risks, we'll look at the options table courtesy of Yahoo Finance. The option you select is up to you, but the absolute minimum we'd consider using would be options 6 months out. To best replicate the play, you'd want to use puts that are 1 year or even 2 years away. Just for fun, we've pulled up a list of the put options that expire in January 2011:

(click to enlarge)

We also want to mention that when looking at the puts you have to be wary of premium as some investors have already piled into various strike prices and expirations over the course of the past year. Not to mention, many investors are not fond of using LEAPs (long-dated puts) for various reasons, but if you want to make this play you don't have much of a choice. That's a whole 'nother debate but we just wanted everyone to be aware. You could always just sell short the ETF outright instead of using options, but there are pros and cons to doing that too. For the purpose of this article, we're focused on how best to replicate Julian's play in the retail arena, where options are a better representation than the shares themselves.

We also wanted to toss out another idea by playing the exchange traded fund: ProShares Short 20+ Year Treasury (TBF). Instead of buying puts on this ETF, you would be buying calls on it since the ETF itself is already short the long-term bonds. This is not a leveraged ETF so you don't have to worry about extreme compounding skews from the underlying index. However, do note that it still seeks to replicate the daily performance of its index so there is still potential for slight tracking error. So you can really play it two different ways in the options markets, dependent on which ETF you select. Last but not least, we want to make sure you know that this is not investment advice and make note of the disclaimer at the bottom of our site.


Embedded below is the interesting 30 minute interview with Julian Robertson:

Other Hedge Fund Legends Bearish On Long-Term Bonds

So he clearly is still fixated on the long-term bond portion of the play where he thinks rates are headed much higher due to quantitative easing and the printing of money by Helicopter Ben & the Federal Reserve, amongst other factors. There have been many hedge funds in some form of this trade as we also detailed John Burbank & Passport Capital's curve steepener play. Robertson sees rates potentially skyrocketing in an 'armageddon' scenario where China and Japan cease buying US bonds. Other hedge fund legends bearish on these bonds include Michael Steinhardt, who has labeled treasuries a foolish play. Steinhardt ran one of the first successful hedge funds (Steinhardt Management) and earned 23% a year for almost 30 years. We've also seen ex-Quantum fund manager Jim Rogers speak out against long-term treasuries as he has been short them in the past. There is definitely a confluence of smart minds here as they share similar sentiment.

We track Julian because he is a hedge fund legend in his own right for his work with Tiger Management. Not to mention, he has spawned a huge network of 'Tiger Cub' hedge fund managers that have gone on to start their own funds, many of whom we also track. (You can see a 'Tiger Cub' family tree here). Last, but not least, Robertson also called the downturn back in 2007 as he proclaimed we would be in for a doozy of a recession. He has built up quite the track record and so is at the very least worth paying attention to. It has been reported that his investors received a compound rate of return of 32% during the 1980s and 90s.

Outside of his curve caps play, he did mention a few other plays he was considering. While he hasn't put it on yet, he is considering shorting copper. This play is interesting because 'Tiger Cub' Paul Touradji of hedge fund Touradji Capital had previously advocated shorting copper. During a previous hedge fund manager panel, Touradji advocated shorting copper as the world deleveraged and the velocity of money dropped. Robertson had already shorted copper last year unsuccessfully, but got out of the trade. As we've noted on the blog before, many of the Tiger Cubs end up putting on the same positions and undoubtedly still keep in contact with each other. In terms of currencies, Robertson says the only currency worth being in is the Norwegian krone. And lastly, in terms of equities, he said he is still in Mastercard (MA), Visa (V), and Apple (AAPL) but is not as enthusiastic about being long stocks as he is about being short bonds. Those stocks are the ones he suggested buying in his last media appearance on CNBC almost a year ago and he is up substantially in those investments. He had also recommended Baidu (BIDU) back then, but has since sold out of it.

As always, we'll continue to keep track of Robertson's scarce media appearances. In the mean time though, we highly recommend hearing Julian speak through our discount to the Value Investing Congress where he and numerous other prominent hedge fund managers will present actionable investment ideas. Make sure to use code: N09MF3 to receive the discount. If you're unfamiliar with Robertson, you can always check out our profile/biography on him here.

For more on 'smart money' investment plays, check out Goldman Sachs' list of possible long & short strategies in the current market, as well as their hedge fund trend monitor that lays out hedge fund portfolio holdings. We'll of course continue to track all the latest positions and strategies that prominent hedge funds are pursuing.

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