Replicating Julian Robertson's Constant Maturity Swap (CMS) Trade ~ market folly

Wednesday, October 21, 2009

Replicating Julian Robertson's Constant Maturity Swap (CMS) Trade

In a previous post we covered hedge fund legend Julian Robertson's updated play on higher interest rates. He calls them curve caps and they are essentially constant maturity swaps (CMS) that you can buy on an institutional level. He likened the trade to buying puts on long-term treasuries and so we showed how you could replicate that play on a retail investor level. However, there are obviously vast differences between that and the exact play Julian has put on. As such, we've got a great guest post for you that shows how you can replicate his play on an institutional level. Not to mention, fellow hedge fund manager David Einhorn recently revealed he is buying similar plays as well.

Various investment banks have been out pitching these plays for a while now, but you can be they've certainly been hitting the pavement even more now that Julian has been so vocal about his play. The following is a guest post from to explain how they are pitching a replication of Julian's play:

"It is no secret that Julian Robertson is not a huge fan of long-dated bonds. In his recent CNBC interview he had some downright nasty words about the back-end of the UST curve, especially if the "downside contingency" case of foreign purchases ceasing, were to pass. However, while many have known about his propensity for the bond steepener trade, his latest trade position is the so called Constant Maturity Swap trade. Moving away from an outright steepener makes sense as it can now only profit from a tail end widening, since the front end of the curve is at zero. Unless Bernanke follows Sweden into negative rates territory, the steepener upside potential has just been mechanically limited by 50%. As for his current preferred iteration of expressing Treasury bearishness, CMS, here is some recent commentary from JR on the topic:

"The insurance policy I would buy is called a CMS 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."

No surprise then, that Morgan Stanley's Govvy desk has started pimping this trade (including some hedged and Knock Out variants) to anyone who wants to imitate that original Tiger. In a recent version of their Interest Rate Strategist, the key proffered trade is precisely Shorting back-end rates, with the following summary recommendations:

  • Buy a 5 year Cap on 30 year CMS struck ATM (5.38%) for 105 bps
  • Buy a 5 year Cap on 30 year CMS struck ATM. Sell a 5 year Cap on 30 year CMS struck at 8.38%, for a net cost of 65 bps.
  • Buy a 5 year Cap on 30 year CMS struck at 5.38% that knocks out in 1 year if 30 year CMS is above 5.38% for 62 bps.

Here is MS' entire modest proposal:

In the past month, longer-dated volatility has declined and longer-dated rates have rallied (Exhibit 1). Getting short back-end rates – with defined downside – is becoming increasingly attractive. We maintain our long-held belief that, in the long run, the curve will steepen significantly, and we continue to believe that long-dated rate caps will benefit from the higher rates and higher volatility that will come from increased Treasury issuance and an end to the public stimulus programs.

Specifically, we propose a selection of the following trades:

  • Buy a 5y cap on 30y CMS struck ATM (5.38%) for 105bp
  • Buy a 5y cap on 30y CMS struck at 5.38%, Sell a 5y cap on 30y CMS struck at 8.38%, for a net cost of 65bp
  • Buy a 5y cap on 30y CMS struck at 5.38% that knocks out in 1y if 30y CMS is above 5.38%, for 62bp

Inflation and long-end supply remain substantial concerns, particularly for longer maturities. Our economists expect 10y UST gross issuance to more than double from 2008 to 2009, and for 30y UST gross issuance to more than triple. After 2009, we also project 10y UST issuance to increase by $40 billion per year, and long bond gross issuance by approximately $50 billion per year (Exhibit 2). This is while the Fed is projected to keep short-term rates on hold in order to stimulate the economy and maintain a steep curve.

We aim to target 30y rates. This is because we project 30y UST gross issuance to keep increasing at a faster pace than 10y gross issuance (Exhibit 2). Moreover, we expect the curve to steepen in periods of high inflation.

We also target longer expiries (3-5y). Two reasons behind this: first, we have been in a secular downward trend in longer-term rates since the mid 1980s (Exhibit 3). This is a trade for us to break out of that range – we expect such a shift to occur over a longer period of time as opposed to in the next year. Second, flows out of lower yielding money market funds into the belly of the curve are expected to keep longer rates bid, at least for the next couple of months, in our view. This is something that we can exploit by entering into a knock-out cap.

Investors looking to decrease the upfront cost of the option can accomplish this in one of two ways: either by limiting their upside, or by playing the timing of the sell-off in longer-dated rates.
Limiting the upside would involve selling an OTM cap against the ATM cap that the investor is long. For instance, if the investor sells a 300bp OTM cap against buying long an ATM cap, this cheapens the upfront cost of the option to 65bp, or by 38%. Note that OTM skew on longer tails has richened substantially over the past three months. Exhibit 4 graphs the spread between 100bp OTM 5y30y payors and 100bp OTM receivers, normalized by the level of at-the-money vol – the higher this spread, the more expensive payor skew is relative to receiver skew. Over the past three months, OTM payor skew has become increasingly expensive. This is why we prefer monetizing and selling it as opposed to moving the strike of the CMS cap that we’re long further out of the money.

Playing the timing of the sell-off in longer-dated rates would cheapen the upfront cost of the cap by selling a shorter-expiry option against the longer-expiry cap. Flows out of money market funds into the belly of the curve are likely to keep the long end somewhat bid in the near term, in our view. Investors can monetize this by entering into a 5y cap on 30y CMS rates that knocks out in 1y if 30y CMS is above a strike of their choosing. For instance, a 5y cap on 30y CMS struck ATM (5.38%) that knocks out in 1y if 30y CMS is above 5.38% has an upfront cost of 62bp; if investors move the strike of the knock-out to 6%, the cost increases to 79bp. Note that a 2y knockout cheapens the cap even more than the 1y knockout. The principal risks to the outright CMS Cap are either that rates continue to rally, or that vol falls. Note that both of these risks are mitigated with a 1x1 cap spread, or with a knock-out cap. In each of the three trades, however, the maximum downside for investors is equal to the initial premium invested.

If last week's pounding of the 30 year is any indication, Robertson may just be on the right trade yet again. The demonstratory selling of 30 years both into and after the Auction was obviously agenda driven, and it is doubtful it bypassed Bernanke's, and the PD's attention. Yet as China is increasingly boxed and realizes fully well it needs to buy some Treasuries (lest it sends the world a signal that it is willing to write off its $2.5 trillion in dollar reserves), it is conceivable that going forward it will merely focus in the 1-3/5 Year Tenor range, as it leaves anything 10 years and out to other, Fed financed chums. Some desks have in fact argued that what the ABX trade was for subprime, and CMBX was for CRE, the CMS trade will end up being for Treasuries. Although be careful: while your opponents in the first two were subprime borrowers and Cohen & Steers respectively (hardly admirable opponents), in the last trade you are taking on the Federal Reserve and the full faith and credit of the US head on. For if the Fed losses control of the 10-30 year span, it might as well go home, since that means 30 Year mortgages will skyrocket,maybe all the way into double digit territory, thus destroying all hopes of inflating the GSE bubble.

Yet as Soros showed in the 90's, Central Banks can lose. All that needs to happen to topple Ben, is for the bond vigilantes to come out in force and support Robertson's fatalistic view on USTs. Not even the worlds most overheating printing press can take on the combined power of all the bond vigilantes in the world. Although, it is arguable if one can take on the Fed via passive strategies such as CMS. Someone with real guts would have to be the first to go all out and short the back-end. If substantiated by a sufficient number of synthetic bearish positions, at that point it will be merely a matter of time before Bernanke is finally forced to fold his endless deck of Aces.
For some additional color on CMS, we recommend this paper from Goldman Sachs."

Thanks to ZeroHedge for the guest post on how to replicate Julian's play on an institutional level. Don't forget to also check out our post on how retail investors can replicate his play to some degree.

Julian's been quite active lately and we've just covered his market thoughts that he presented at the Value Investing Congress. For more of his insight, also check out his recent interview here (and another here). Lastly, if you're unfamiliar with the Tiger Management founder, check out our profile on him as well.

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