I figured it only natural while Hank Greenberg, former AIG CEO, explains to the public of "How AIG Went Off Track" that we touch on Kyle Bass's views on the market, especially when he quoted, "The AIG of the world is back" referring to banks selling him one-year jump risk at 1bp on Japan.
Let's take a step back and really breakdown what is going on. What is jump risk? Jump risk is the risk associated with huge unforeseeable swings in market prices, which are more commonly used on the street as "fat tails" regarding the tails, very unlikely events occurring, on a distribution curve of possibilities with respect to a certain scenario.
First off who is Kyle Bass and why do I care? Kyle Bass is the founder and principal of Hayman Capital management, which is a Dallas based hedge fund that made a name for itself during the 2008 crisis, as one of the few that predicted the collapse of the subprime mortgage market by buying credit default swaps, insurance against default, on subprime bonds and CDOs or collateralized debt obligation. He also has been publicly short Greece and other Eurozone nations, and now in the last couple of months has been publicly expressing his view on the inevitable collapse of the Japanese economy.
So what kind of ruckus is Kyle Bass stirring up and how can you play his views? First off, he is short Japan, very short. Kyle is bearish on anything with a Yen denomination.
Kyle's view is that Japanese debt is about 24x government tax revenues and there is nothing Japan can do to get out of that insolvent hole. More concerning, now with Japan targeting a 2% inflation rate they are going to implode even sooner. But why? Currently, institutions can buy two-year Japanese government debt at 2bps, five-year debt at 12bps, and ten-year debt at 62 bps. Kyle says that the only way that anyone in their right mind would buy these securities is if they were promised deflation. Deflation is a period of a decrease in prices, the opposite of inflation. Contrary to intuitive thought, sustainable deflation is a very bad thing and hard to control. Deflation causes corporations to sell their products for a lower margin, or cheaper prices which causes corporate profits to decrease, which leads corporations to scale back production and reduce employee wages, which inevitably leads to firing workers. Long story short, deflation is bad for riskier assets like equities and bullish for fixed income, more specifically safer government bonds. So, why would investors continue to buy JGB if Japan will no longer promise deflation but, rather guarantee inflation. If investors do not buy JGB then interest rates will rise, then the Japanese government will begin to spend more money on interest on their debt than anything else, causing them to inevitably default.
The everyday retail investors can not go out buying CDS on Japan unless you have some serious connections and a lot of luck, like Charlie Ledly did, so how do you play Bass's view? There are multiple ways, some more direct than others.
- You can directly short the Yen with ProShares UltraShort Yen (NYSE: YCS). YCS seeks to gain the inverse of the daily performance of the USD price to the JPY. YCS was up 23.32% in 2012 and is up 13% YTD. YCS currently trades at a 0.31% discount to it's NAV (what you want to see), it does an average daily volume of 340K shares (plenty liquid), and has a manageable expense ration of 0.93%.
- You can short Japanese Government Bond Futures with PowerShares DB 3x Inverse Japanese Government Bond Futures ETN (NYSE: JGBD). This is a Deutsche Bank launched 3x leveraged ETN that seeks inverse correlation to it's index, the DB USD JGB Futures Index. This Index is long 10-year JGB futures. It trades relatively at par to it's NAV, it has a management expense ratio of 0.95%, however it only trades 24K of average daily volume, which is relatively illiquid.
Indirect way ( Personally, my two favorite ways):
- You can go long Asia excluding Japan with hopes that other Asian economies will continue to prosper and grow without Japan using: iShares MSCI All Country Asia ex-Japan Index Fund (NASDAQ: AAXJ). AAXJ gives its investors exposure to 10 developed and emerging Asian companies, excluding Japan. This portfolio structure enables investors to seek some diversification both geographically and on a risk basis. AAXJ is heavily weighted in financials (27%) and technology (19%), with very little exposure to defensive securities like healthcare, utilities, and consumer staples (10% all together). This bears more risk than your US domestic equities, however investing in the ever popular and expanding Asia will usually cause investors to hold more risk. Relative to other emerging market pure plays, this is a relatively defensive way to invest in Asia without holding the risk of yen denominated assets. You will also get a tailwind with the depreciation of the yen, as a depreciating yen helps importers of Japanese goods, aka large Japanese corporations with significant international exposure.
- You can go long Japanese yen-hedged equities with WisdomTree Japan Hedged Equity (NYSE: DXJ). Let's face it, Japanese equities have been pretty much terrible over the last 20 years due to a sluggish economy, deflation, and an ever appreciating yen. DXJ tracks a dividend weighted index, as opposed to the price-weighted Nikkei Index. The main difference between the Nikkei and DXJ is that the Nikkei index has less exposure to large-cap exporters, while DXJ does not hold any companies with 80% or more of their revenue coming from Japan. This ETF holds many companies that are large global players in the auto, electronics, and machinery industry. These companies have very clean balance sheets and are well-positions to conduct M&A activity. DXJ has plenty of liquidity, trades at a discount to NAV, and has a 48bps expense ratio, which is the lowest out of the above listed investment vehicles.
Currently, I would be looking to play Japanese corporations that are expanding internationally, especially those that are doing significant M&A and paying in yen for those deals, so that more of the company's revenues are denominated in the local currency than yen moving forward. I would steer away from corporation expanding into the Euro because who knows when the European Sovereign Debt crisis will gleam its ugly head again, which has happened every summer for the last three summers.