Description

We are recommending the purchase of long-dated interest rate caps. There are numerous options available to investors; we favor caps on the 10-year swap rate (Bloomberg: USISDA Index 10) with a five year maturity, and we will illustratively consider a strike from 4.5% in this write-up. We saw the post earlier today on shorting Treasurys or related ETFs outright, and we offer this mechanism as an alternative for investors holding a similar point of view but looking for more of a limited downside structure. 

US Treasury rates are at historical absolute lows (and also relative to inflation). We view this investment as insurance against higher future US interest that could emerge due to a reversal of easy monetary policy, future inflation or dollar debasement.  As the US stares down deflation, higher rates are not a near-term concern. The US could follow in Japan’s footsteps over the next several years which would portend a continuation of low rates; but the Fed and the Treasury are determined to inflate our way out of the current economic crisis, and there is a chance their policies may work (or overshoot) over the longer-term.    Because the market is preoccupied with the deflation, the insurance can be purchased quite inexpensively and structured in a way to provide outsized payoffs under plausible scenarios for the patient  investor. 

Please note that the pricing info quoted in this write-up is as of Tuesday December 23, 2008. For reference, the 10-year Treasury was at about 2.22% and the 10 year swap rate was at about 33.75 basis points over Treasurys. The indicative prices on the rate caps represent broker dealer quotes.

Thesis

We are not macro investors, and the best we can do is position ourselves for potential states of the world, especially in managing risk. As the country grapples with its deflationary present, we see little concern in the market about an inflationary future.   While the market largely looks the other way, we, however, worry about some the following developments.

·         Fed Balance Sheet Expansion. The Federal Reserve’s balance sheet has ballooned from about $800 million in late 2007 to over $2.2 trillion today. This has expanded the monetary base massively, but the velocity of money has stalled as banks are holding on to reserves and credit contracts. Ben Bernanke and the Fed have made it clear that whipping deflation is priority number one.  In the last few weeks, the Fed has announced that it will begin purchasing “large quantities” of agency debt and mortgage-backed securities to provide support to the housing market, and it stands ready to expand such activities as conditions warrant. The Fed intends to employ a growing toolkit in its quest to re-inflate the economy. The overall market may be willing to bet against the Fed and continue bidding down Treasury rates, but we think it is certainly possible that Bernanke and team will succeed in their efforts to engineer inflation. What’s more, we think it is possible they overshoot or that reining in the liquidity does not prove so easy and painless once inflation emerges. 

·         Dollar Depreciation Risk. The US has been relying on foreign capital to finance our deficits.   This has worked fine because the US enjoys the dollar’s status as the parking lot currency for the world, which is based solely on the worldwide trust for the dollar. Foreign investors and foreign central banks could become concerned about the dollar, or they could simply require a higher return for long-term money (i.e., more than just over 2% for lending to the US for ten years), pushing up US Treasury rates.

·         US Government Fiscal Deficits. Since 2001, the US government has been running record annual budget deficits. The US Government must issue record amounts of debt to finance the swelling deficit. In fact, recent Treasury plans call for a record of $2 trillion of Treasury note issuance next year, and President-elect Obama’s team is preparing a fiscal stimulus of as much as $850 billion. There may be additional expenditures related to a multi-year mortgage rescue program, auto bailout, etc… We wonder whether the US can continue to finance all of this activity at such historically low rates.

·         Investor Flight to Quality. Rates have plummeted in the past year as investors have sought what they consider to be the relative safety of US Treasury securities as the stock market and corporate lending deteriorate. The financial press is littered with stories detailing investors fleeing to the “safest securities” to safeguard their principal from wider losses.    We think investors will eventually begin to seek yield, especially if inflation re-emerges, and their willingness to accept negative long-term real returns could sharply reverse. Moreover, the widely-held investor perception of the safety in long-dated Treasuries could correct once these investors experience significant mark-to-market losses on longer-term maturities s as the term structure shifts upward. We think there is a real possibility that we may now be watching the cresting of a bubble in Treasurys.

·         Global Stimulus and Easing. The unraveling of credit in the US is bleeding globally, and this certainly argues for low rates. But, other countries, such as China and India, have embarked on their own massive fiscal stimulus and monetary easing plans which could help cushion the overall global slowdown.

We believe these factors could reinforce a rising rate environment in the next few years.

The Structure and Trade

We have evaluated a variety of products to express this point of view. We did not desire to take on an outright short position on the Treasury or related ETFs, especially as the Fed may begin purchasing long-term Treasurys through a policy of quantitative easing in the near-term. Rather, we looked for a product that provided sufficient liquidity, a long-term outlook and a limit to our downside risk while offering a significant payoff.    We recommend the purchase of rate caps, which provide a European-style call option on the underlying interest rate. The typical reference rate is the Constant Maturity Swap Rate, which reflects an interbank lending rate (and converges to Libor over the long-run). The Constant Maturity Swap Rate typically trades at a slight premium to Treasuries to reflect the credit risk of interbank lending. For longer-dated options on rates, Constant Maturity Treasury Rates are not widely offered so the swap rate provides a deep pool of liquidity and is widely assignable among most fixed income broker dealers.

The payoff of the structure is: Maximum of (0, Reference Rate at Expiry – Strike) * Notional Amount. The expiry of the option we show here is five years, which provides a fairly large window during which the direction of the economy and market expectations can change significantly. The rate is set at a constant maturity so that no matter how long the option is dated, the duration of the rate at expiry remains at a fixed point on the yield curve (i.e., the payoff profile does not decline as rates rise due to convexity).   The downside in this structure is limited to the investor’s upfront premium. Below we show the payoff and profit/loss assuming a $5 mm cap which is held to maturity.

5 Year Cap on 10 Year Constant Maturity Swap Rate (CMS)

Strike (10 Year CMS): 4.50%

Premium: 0.497%

Break-even yield on 10 yr CMS: 5.00%

Illustrative Notional Amount: $1,006,036,217

$ Premium (Cost): $5,000,000

10 Yr Swap spreads to Treasurys (assumed at current levels): 30 basis points

One can pay more for a lower strike or pay less for a higher, more out-of-the-money strike.   The 4.5% strike is about 135 basis points out of the money compared to the forward curve (which is shown on Bloomberg at FWCM).  This provides a very large notional amount of $1 billion in this example. Our premise is not mean reversion, but let’s consider the case where the 10 year Treasury simply reverts back to its 40-year mean of 7.5% in five years. Assuming a 30 bp spread on swap rates (which low historically, and the purchaser would benefit if swap spreads widen over the option’s life), the investor who bought $5 million today would receive $33.4 million (or 6.7x his money) at expiry for a profit of $28.4 million. We wanted large potential payoffs at higher rate scenarios so we selected this out-of-the-money strike.

Risks

We recognize that the macro-economy is nearly impossible to predict, but we are proposing this because we believe it represents inexpensive insurance. This protection is cheapest when the market is looking the other way. That said, many things could impair the market value of these options or render them worthless.

·         Counterparty Risk.  These options are purchased from a large bank that we must rely on for the ultimate payment. We were left to choose our favorite neighborhood broker whom we hope is now too big to fail.

·         Credit contraction. Expansion of the monetary base will only spur inflation once the money multiplier recovers as banks resume lending.

·         Quantitative Easing. As the Fed embarks on a policy to purchase longer-dated maturities of Treasury securities, the policy could successfully push rates even lower. While this could reinforce the thesis longer-term, it would create an adverse mark-to-market.

·         Continued deflation and recession. A failure of the economy to recover would likely suppress rates, as happened in Japan where rates have remained at depressed levels for many years. 

·         Flight to Quality. Unquenchable investor demand for Treasurys could continue to curb any upward trajectory in rates.

·         Decay. The value of the option premium decays with time.

Catalyst