Thursday, December 27, 2012

Credit spreads and fiscal cliff

If tax rates increase, as is expected, the post-tax cost of equity will rise and the post-tax cost of debt will drop, everything else kept equal.  With regard to debt in particular, this means that corporations will issue less equity and more debt going forward, and they accept higher yields on the debt that is issued.  In addition, investors will demand higher yields b/c they would otherwise see less yield post-tax.  These effects will be amplified with higher-yield debt since the effect is a % of current yield.  Thus, I expect credit spreads to widen, w/ junk bonds underperforming investment-grade.  The benefit of structuring the short junk bonds position as a pair against investment-grade instead of naked or against something else is that the long investment-grade position hedges out much of the impact on junk-bond prices that I dont wish to bet on, such as general risk appetite or in/outflows to/from corporates in general.  I am using the ETFs JNK and LQD to put on the trade, and I'm taking a larger position in LQD than JNK b/c JNK's "beta" is larger.

This trade would have worked briefly in early Nov when the market was also panicking out of numerous high-dividend equity stocks.  Bond spreads have tightened and high-dividend stocks have bounced for the most part ever since until the last couple days.  My bet is that the market has been ignoring the potential effects of the fiscal cliff for too many weeks with respect to these trade categories.  Particularly w/ respect to bond risk spreads, I believe that the risk of a large tightening is limited even should politicians come to an agreement to restrict tax increases even somewhat, so I plan on taking this particular position through any upcoming political meetings, votes, decision-making sessions, etc.

In addition, the cliff will bring about a weakened economy, so this should also contribute towards widening spreads.  Of course, this trade has negative carry, so I don't want to hold too long, but perhaps several weeks or months would be appropriate to allow the markets sufficient time to price in economic deterioration and changes in post-tax cost of debt.  This might be a kind of delayed sleeper trade that works later than the other fiscal-cliff-type trades and wont work until corporate CFOs start actually raising more capital and the bond folks start seeing bond issuance suddenly spike and think of this trade.

I had written earlier about looking to short private equity firms due to risk that their carried interest benefits will be cut.  However, I neglected at that time to consider that they'll have far more buyout opportunities opened to them due to the fact that companies would be able to handle higher debt leverage ratios with the imminent reduction in cost of debt.  That could be a good reason why many buyout firms have outperformed lately.

Muni bonds have sold off in the last couple weeks ever since they became a target for a tax loophole elimination--namely, that rich investors will have to start paying taxes on muni dividends.  While that change to muni bonds is drastic, this is the same kind of consequence that should take place on a subtler scale to credit spreads.

Fiscal cliff and deadline

With the recent news that the House will be reconvening on Sunday, I just find it funny that politicians believe that there's a kind of deadline to make a law by the very end of the year, when investors must make decisions in anticipation of tax rates before then.  Long-term gains or losses must be locked in by the end of trading on Monday, not by midnight.  If one is trying to move a large position, then trades must be executed over the course of several days before the end of trading Monday.  Politicians of course have no clue that they are creating this uncertainty.  As for a self-imposed mental deadline of Monday night, I'm not sure who that particular timepoint will affect.  Of course businessmen must make decisions in general depending on tax rates, and this uncertainty continues for as long as a deal is pending.  For them, no particular date is more important for a deal than another date.  So I'm not sure why the House is needed to be rushed back now; the deadline is pretty much already blown for any large investors, and there is no particular deadline for businessmen.

I have been long numerous small cap former-losers against short large caps and high-dividend stocks pretty much all month (the January effect, which, due to the fiscal cliff, has taken place in December).  This has served me somewhat well in December, at least as far as many small caps becoming strong this month.  I would like to flip this trade for an un-January-effect trade for January 2013 as long as I can be confident that any deal that will be made will keep taxes higher for many investors.  We'll see as the news progresses...

Wednesday, November 14, 2012

More fiscal cliff plays

I've been making nice plays shorting high dividend funds trading at large premiums to NAV such as PGP, PHK, CFP, any other high-dividend investment firms, and mortgage REITs such as IVR.  I remain short all these at the time I'm writing this, but that may or may not change soon.  The next sector to get smacked in anticipation of the fiscal cliff could very well be buyout firms, whose 15% carried interest advantage is at risk.  They haven't really budged yet.  I will start looking to short CG, KKR, BLK, FIG etc in coming days.

Friday, November 9, 2012

Fiscal cliff

If history is any guide for disagreements like this fiscal cliff, nothing will get done until the last 24 hours, then agreements will almost certainly be made before the deadline, or else an agreement will be made to delay the cliff until an agreement is made later.  So to the extent the market is worried about it, the market willl generally sell off for 2 mo, then gap up on deadline success.  However, I'm not sure whether the market will be very worried about it.  I made keep a bearish bias until the deadline nears, however.


Spot gasoline collapsed quickly after my last blog post, and I had to get out for around flat after being up a fair amount.  Since then, spot prices stabilized and created another slightly bullish structure as Hurricane Sandy approached NY, so I reentered Sunday night before Sandy hit.  Today it's starting to pay out some.  No reason to get out yet...

Wednesday, October 3, 2012

RBOB gasoline

The spot price of gasoline in NY has been sky-high lately.  For this reason, I'm long a bunch of Nov futures at this time, hedged w/ a short in WTI crude.  A seasonal drop in gasoline spot prices this time of year isn't enough to eliminate the large backwardation that is the wind behind my back.

Today petrol inventories were released, which showed a drop for crude and build for gasoline, which temporarily took prices against me.  By the end of the day, the spread totally reversed and put me at slightly green.  It gives me confidence that the unfavorable move was news-induced.

With the election approaching, Obama may start freaking out if gasoline prices spike.  The first thing I would see him doing is releasing more of the SPR crude inventory, which would only be indirectly bearish for gasoline, but more bearish for WTI, so I feel safe in this trade were this to occur.

Tuesday, August 21, 2012

Precious metals

Gold/silver, platinum are now all about important swing resistance in USD terms.  Platinum in particular made a very large move up in the last 3 days.  Historically platinum tends to trade at a tidy premium to gold, but has been trading at a discount to gold for awhile now.  I bot some platinum futures this morning at around 1507 to join the extra silver I purchased above the break around 28.30 yesterday.  I think this obscene strength in platinum is telling me something.

If I don't get stopped out, I plan on holding these for very large gains for months or years to come.  It's about time the macro theme of global currency printing on the backs of low interest rates jumpstarted precious metals for another upleg.

Friday, August 10, 2012

Big macro trade on impending Australian housing bubble burst

The current Australian yield curve looks ominous:

The 3-month rate, which isn't displayed on the chart, is also up by 3.5%.  According to the liquidity preference theory, the yield curve should almost always uptrending, as shorter-term lenders implicitly retain the option to not re-lend later, while longer-term lenders do not.  Therefore, longer-term lenders are compensated more.  Borrowing short-term and lending long-term is how banks make money, and how they get into trouble when they suddenly can't borrow short-term to keep funding the long-term debt.  In this case, the expectations theory seems to be telling us that the market expects short-term rates to drop in the next couple of years.

Now why is that?  It appears that the Australian housing market, which is widely written about as being overinflated on various fundamental bases, appears to be still in the early stages of a bust similar to what the US has just experienced.  Australian government data shows the peak of the experimental all-dwelling price index occurred at the end of 2010, and has been downtrending since.  Since the government only has the incentive to show a continuing price uptrend, the fact that it isn't means that I trust the data is unmanipulated.

Interestingly, Australian banking and homebuilding equities have barely bounced since the US-led global financial crisis of '08, even though Australian housing prices still bounced strongly after '08, so it appears those markets have already anticipated a future housing bust.  So the better trade that remains is the yield curve trade.  The market is telling me in the yield curve that it expects the gov't to drop rates.  However, the strip of 3-month bill futures going out 3 years is not telling me the same thing.  This offers me a risk-free arbitrage, whereby I borrow Australian money for 3 years at 2.7% via a 3-year future (via YT futures traded on the Sydney exchange) and lend money for 3-months at a time at rates varying between 3.5% and 3.1% (via IR futures traded on the Sydney exchange), depending on the particular future expiring between Sept '12 and 3 years from then.  I pick up positive carry, all while retaining the option not to re-lend, which the liquidity preference theory would say is backwards.  This trade would be purely risk-free in terms of locking in a guaranteed profit as long as I hold to the 3-year maturity.  Any marked-to-market losses caused from the arbitrage blowing out further would be perfectly matched by increased positive carry going forward.  The problem is that my brokerage doesn't allow me to accept or supply physical delivery of bonds, so I'm forced to roll over any expiring futures.  So I can't ever deliver a 3-year bond at a locked-in 2.7% and receive a consecutive series of 90-day bills locked in at higher rates.  Instead, I have to count on this kink on the yield curve being unsustainable while rolling over the futures.  The nice thing is that this means my upside isn't limited to the 0.4-0.8% yield difference.  Instead, the yield curve can revert to a normal uptrend and give me the additional spread usually occurring between the 3-month and 3-year.

The 3-year rates are decided more strongly by the market, while the short-term 3-month rates are dictated by the Australian central bank.  Also, the Australian inflation index is running close to 1%, giving the RBA plenty of scope to lower rates without sparking overinflation.  Given this fact, along w/ the other indicators given above indicating the housing market is coming down, I'm guessing the RBA will have to stop fighting reality ( and and short-end rates will have to come down soon.  Rather than make an outright bet on dropping short-end rates, I will make the spread trade against the 3-year bond in order to:

1) reduce day-to-day and intermediate-term volatility, thereby allowing me to increase leverage on the idea, and
2) hedge against the risk that the market on the 3-year rates is wrong in anticipating a housing bust and/or lower future short-term rates.

Basically, I'm betting that this curve kink is unsustainable.  Since, like I wrote earlier, the futures going out a couple years on the 3-mo bills don't even price in a rate drop, I will be placing my bet in that timeframe, and rolling over front-month 3-year futures until the curve appears normal.  Some things to look for to ensure the trade should work (besides being green on the trade) is to continue monitoring home price data for continued drops, and to look at the long-end of the curve to see if the 10-year yields start to tip downward even more relative to the front-end, which would be the market anticipating that current conditions are causing long-term disinflation--a kind of market forecast that the CPI won't be spiking anytime soon in spite of whichever monetary or fiscal concoctions Australia formulates.

Another trade to monitor is the spread between interbank rates (IB futures on the Sydney exchange) and RBA bill rates, which is currently very low.  This is similar to the TED spread, but unlike LIBOR, which has been under the microscope lately for being easily maniuplated, the interbank rates in Australia are based on actual market lending rates, rather than hypothetical rates volunteered by the banks.  The interbank (IB) rate futures are standardized at 30-day timeframes, so the durations on those don't line up directly with the 3-month RBA bills, but they're close enough in my opinion.  I will be getting long the spread down the road if home prices continue falling and bank stocks drop more, causing large losses in the banks and spreading fear among them to loan to each other.  To the extent the spread widens contemporaneously with the downslide, I will be riding the trend.  However, as a trader, I have no problem arriving late to the party to mop up when it's the most fun!  Most smart guys chronically arrive early, and that's why I make money much faster than them.