Monday, March 23, 2015

Structural Dislocations in the Volatility and Sovereign Debt Markets

Investors,
 
   In this post I'll cover some of the biggest structural distortions visible in the market with a few ideas of how to profit from them, or at least avoid getting run over.  The bulk will be on distortions in the volatility market, which requires some technical jargon.  This post is more geared more towards the professional investor/trader than most of my "Risk over Reward" commentaries.  
 
Equity Index Skew
  Asian stock index volatility looks radically different from the S&P 500 because of structured products in Asia and the behavior of US investors.  There are a variety of structured products throughout Asia that aggressively sell long-term volatility, and particularly downside skew (example: "autocallables" in Japan.  These insurance products pay out less when equity markets are down, and so they result in consumers of insurance basically selling long-dated out-of-the-money puts).  The basic theme is that asian investors enhance the yield of all sorts of investment products by coupling them with a sale of long-dated volatility.  This causes the index vol curve of most Asian markets to be much flatter than the US (probably too flat), and to price in much less downside skew (probably way too little.) 
  In contrast, the US has tons of short-term call overwriting and downside put buying.  The short-term call overwriting is done to generate yield for investors like pension funds desperately trying to earn 6%+ on their portfolios; it results in a steeply upward sloping volatility curve.  Downside puts are being purchased more aggressively than ever before by banks because of new regulations (i.e. Dodd-Frank, Volcker Rule, and CCAR) that require stress testing of portfolios and limited risk taking.  Short-term and deep out-of-the-money puts help banks meet the stress testing requirements.  Insurance companies have also increased their buying of short-term puts because of the death of certain types of variable annuities, which previously required them to buy very long-dated downside protection.  
   The simplest application of this mispricing is in a simple hedging scenario.  If you want to buy protection on your portfolio, you should avoid puts on the S&P 500, because S&P put skew is currently overpriced relative to other sources of downside protection.  Instead, consider replacing some of your equity exposure with an out of the money call.  That way you dodge the overpriced puts and benefit from the cheap call skew.  A picture of the put/call skew ratio is attached.  The high number associated with the S&P 500 reflects the fact that the market is pricing puts with much greater skew than calls, unlike in the Nikkei and Hang Seng where the premium on puts is small to almost non-existent.



Energy
  Options on crude oil are trading with an implied volatility of 45 (taking the average of Brent and WTI 1-year option implied vol).  The market is pricing in a substantial chance that crude oil will soon trade below $30.  I've had some recent discussions with analysts who have convinced me that $30 crude is indeed a possible (albeit unlikely outcome) and that crude could potentially stay there for at least a couple years.  While $30 is well below replacement cost, banks can force the oil companies to keep pumping oil to generate cash to pay off the debt that financed the wells.  In other words, crude oil supply may drop surprisingly slowly in response to low prices.  This isn't a comment on crude's direction, but on its probability distribution.  
  In contrast, the options market is pricing  the volatility of the energy large caps (represented by the ETF XLE) at only 20 vol, and even smaller E&P companies at only 50.  Many of the E&P companies will go bankrupt with oil below $40 and are worth much more than where they're trading if oil rebounds above $70; they're a heavily levered bet on the price of oil, but the options market isn't reflecting that.  The simple trade is to sell volatility on crude oil futures and buy vol on energy companies (both E&P and broader large-cap).  The more sophisticated version is to do the same, but also buy the debt of these companies (especially E&P which are severely discounted) and short the equity as well.  The latter trade looks like owning delta hedged convertible debt against crude vol.  
  
Sovereign Debt
  We all know about how central bank buying has artificially suppressed interest rates, but only recently have investors become totally complacent about the negative nominal interest rates that a good chunk of the developed world is now exhibiting.  The following countries are all being paid by investors to borrow money for 2 years, i.e. they have negative nominal interest rates: Germany, France, Belgium, Austria, Sweden, Czech Republic, Switzerland, Finland, Netherlands, Austria, and Denmark. In many spots, the market is offering staggering reward for relatively low risk to the investor.  For example, shorting Japanese debt (or buying vol on it) may fail as a trade, but you can structure it to offer you 5:1 or better.  Instruments like the LIBOR-OIS spread and equity puts contingent on a currency move offer similar payoffs.  One very specific trade that I like is buying equity puts contingent on higher interest rates. The pricing of this trade depends on the implied correlation between bonds and equity.  The biggest player in this market are pension funds who need to hedge the risk of equity falling while bonds rise (in which scenario the present value of their liabilities increases and they face a funding shortfall), and so these behemoths sell down the implied correlation between equity and bonds to artificially low levels.  By taking the other side of the trade (betting that bonds and equity will move down together), we can buy puts at highly subsidized prices.  Currently, the implied correlation is so low that you can save roughly 70% of the premium on the puts.  
  The pattern of interest rate suppression and volatility selling by investors may continue, but it provides a fantastic opportunity to construct asymmetric trades with great reward for minimal risk. Unfortunately, the best trades require the use of OTC derivatives, so they're out of reach for most of our personal accounts.  

Big Picture
  Most assets are overvalued.  US equities and real estate are moderately overpriced; venture capital, biotech, and bonds are in or near bubble territory.  European and emerging market equity looks roughly fair.  I'll provide a more detailed look at each of these areas in my next letter.

Cheers,
Ari