For investors looking for the next "sub-prime" trade, I don't think you have to look too much further than Japanese Government Bonds (JGBs). In about 2005, little known fund managers at the time, like Michael Burry and John Paulson, began betting on what very few were expecting in their wildest imaginations - a material, across-the-board drop in real estate prices in the United States. I'm not going into the details here, but in essence they were buying Credit Default Swaps such that if default occurred of sub-prime mortgages they would receive payouts of $50-$100 for every $1 of CDS they bought. It was the equivalent of buying options where implied volatility was trading at all time lows. This was a classic asymmetric trade, the sort of trade that would forever make you famous, as Burry, Paulson and others became within 12 short months.
I scour the globe for sub-prime-like trades where downside risks are very limited but the upside is extreme - the sort of trade that very few think is remotely possible.
One market that I have been drawn to in recent weeks after watching it with interest over the last 4 years has been the Japanese Government Bond market. I have talked about the poor fundamental outlook on JGBs before on seekingalpha.com. Nothing has changed; if anything, fundamentals have gotten a whole lot worse.
But this isn't what really draws me to position myself and clients for major downside in JGBs (JGBS). It is the absolute certainty that the JGB market will not move at all over the coming days/weeks. Specifically, implied volatility on JGB options (trading on the Tokyo Stock Exchange) is trading at record lows. One can buy short-dated options on JGB Futures for less than 2% vol. I have never seen such low vol in option markets - ever!
The point I would like to make is this - if everyone is so certain that the JGB market will not move significantly up or down, who is left to become certain that it won't move? Being certain that the JGB market will not move is perhaps the most crowded trade on the planet!
The Graph below is the VIX of the JGB Market. Note that implied volatility is the lowest it has been since 2005, and I seriously doubt that it has ever been much lower prior to this.
Index of Implied Vol of 1mth to Exp Options on JGBs
If you do not believe that there is any risk that yields will rise in Japan, then in essence you are making a call that Japan will be stuck in a monetary condition of deflation. But behind the scenes, inflation expectations are rising. Note the behavior of the Japanese 5 year break-even (difference between yields on 5 yr JGBs and 5 yr TIP JGBs), the trend is up in an almost linear fashion. Could I go so far as to say that inflation in Japan will likely surprise on the upside over the coming months/years? Well it certainly seems that the BOJ and Japanese government are determined to create inflation. Inflation is the worst enemy of a nation's bond market.
Japanese 5-Year Break-Even
I know that this isn't a mainstream investing idea, but I think that for those of you who are looking for the next big sub-prime or asymmetric trade, you don't have to look too far past buying puts on JGBs. Given how cheap options are, a few dollars can certainly go a long way.