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SurlyTrader is a portfolio manager at a large financial institution who specializes in trading derivatives. He has been in the financial services industry for over a decade and would like to share his experience and enthusiasm in the financial markets with those who have a natural curiosity and... More
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  • The Bursting Of The "Bond Bubble"

    Many investors are truly afraid of the bursting bond bubble. I have been questioned repeatedly about how worried I am about fixed income returns and rapidly rising interest rates. I generally respond that I do not see any indication of significantly higher interest rates in the near future due to high liquidity (demand for fixed income assets) and lower global growth/inflation. That being said, it is worth taking a bit of time to look at what has historically been a bad bond day.

    The general thought process is:

    "Bonds have been in a bull market rally since the early 80′s with a steady decline in interest rates. Now we are at very low starting interest rates with nowhere to go but up! Imagine if rates go from 3% on the 10 year to 10% in a short amount of time!"

    I appreciate the fear, but here is another thought process. Interest rates have remained low for 5 years. Low cost debt has been "cheap" for companies and qualified investors during that time period. Why does inflation remain stable even though all of this cheap money is available? Maybe the deleveraging cycle can take decades to right itself much as it did following World War II?

    From the return side, let's look at the bad days. If you look at the rolling total returns of the Investment Grade Corporate Bond Index since 1976, the bad 6 and 12 month total returns were shy of -20% in the early 80′s:

    (click to enlarge)

    Funny that the upward spiking interest rates of the early 80′s created about the same negative returns of the credit spread blowout in 2008

    The funny thing about bonds is that their returns are "self-fixing". The bonds move back to Par ($100 per face) price at maturity over time. In addition, the investor continues to re-invest his/her coupons at higher interest rates thereby dampening the changes in price of the underlying bond holdings.

    As a comparison we can look at S&P 500 price returns over the same time period. Total returns are not available back to 1976, but they would be very close to the rolling price returns:

    (click to enlarge)

    Stocks fix themselves as well, but the drawdowns are more frequent and returns are obviously more volatile

    As a last point, I think it is worth looking at some fear that we have talked about with regards to the Eurozone countries in 2010-2012 (the P.I.I.G.S). Spain was definitely in the spotlight of potential default with a banking crisis as the tipping point. If we look at the yield of 10 year Spanish debt, it got to about 7.5%:

    If you look at the short period of time it took to go from 4% to 7.5%, you would expect heavy losses for a nearly doubling of yield

    In reality the total return investor in those Spanish 10 year Govie bonds did not weather that much pain:

    The loss was temporarily close to that -20% we saw in US bond markets

    The scary part of these charts is how much that investor has gained since 2012 and how low Spanish yields have gone. We are now at a Spanish 10 year yield of 3.06% and a US 10 year yield of 2.71%. I think I would rather buy a US Bond than a Spanish bond. This brings me to my final point - worrying about quickly increasing US interest rates ignores all of the other countries with bigger problems. Japan and many of the Eurozone countries are further up on the list of collapse probabilities than the United States.

    We probably should not force ourselves to buy bonds at the abysmally low current yields, but at the same time we should probably be looking for the risk flare up to occur in a different asset class or geographic location.

    Apr 23 10:00 AM | Link | Comment!
  • Replicating VXX Or VXZ

    With a little bit of elbow grease and some knowledge of programming in VBA or another language, you too can recreate the indices represented by VXX, VXZ, or maybe even your own volatility futures index.

    The VIX Futures data is available historically going back to 2004 from the CBOE Futures Exchange. You just need to bring all of the data into a framework that is easily understood from a programmatic standpoint. You can download the data here or shoot me an email if you need assistance.

    The second step is to dig into the prospectus for VXX and VXZ. There is actually quite a bit of information available, just jump to page 20 and 21 of the following pdf:

    Ipath VIX Prospectus

    If the math is scary, you probably do not want to tackle this project

    Once you are able to meld the formula with the underlying VIX Futures data, you will be pleasantly surprised at how accurate your own estimate of the index is:

    (click to enlarge)

    You will not be pleasantly surprised to know that if you invested $100 in VXX at the beginning of 2008, you would have ~$2.70 today…

    May 07 10:18 PM | Link | Comment!
  • Evaporation Of Liquidity

    It seems rather unfortunate that the hack of an AP twitter account can cause more of a disturbance in the market than an actual terrorist bombing in Boston. A 15+ point dive based upon hacked falsehoods:

    (click to enlarge)It seems unlikely that today's rally was a recovery and continuation of the rally that we have experienced since the middle of November. In fact, it seems likely that today's rally was more of a short-covering fueled bounce than a continuation of something "good":

    (click to enlarge)What is actually kind of entertaining in this market is the complete apathy in options and implied volatility. 10 Day realized volatility has ramped up to 20%+, but the VIX dropped to 13.48%. I might be Naive, but I have found that the best indication of future volatility is recent volatility…

    (click to enlarge)

    I am not biting. Euro was down today, gold is slanting negative once more, DBA (agriculture commodity ETF) was down about 1% today. Does not seem like a happy picture going into a temperamental season.

    Apr 23 10:26 PM | Link | Comment!
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  • The Bursting Of The "Bond Bubble" $BND, $AGG, $LQD http://seekingalpha.com/p/1p9q7
    Apr 23, 2014
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    Oct 5, 2011
  • Seems that the dollar has topped out for now. Looking to get long AUD
    May 19, 2010
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