Description

Buying long dated payer swaptions on US Treasuries represents a very compelling risk/reward. 

The upside/downside has improved recently as expectations on forward rates have come down dramatically.  5yr forward 10yr UST rates have declined to <3% back to levels seen only briefly during the financial crisis.  Investors have been consistently burned on going short USTs outright as well as through the derivatives market which has created a compelling entry point.

We specifically like the options on the 5yr forward 10yr rate.  Depending on how out of the money you go, you can make 7-20x if the 10yr gets to 10% over the next 5yrs.  Above, we use the 300bps OTM 5yr 10yr (strike of 5.93%) which cost approximately 170bps.

Why do we think that the 10yr can spike?

There is a currently a bubble in developed market sovereign bonds.  Bubbles are formed as a result of loose monetary policy, significant credit growth and a myth that allows asset prices to be pushed to extreme levels.  The myth today is that developed market sovereign entities are “safe havens” when in reality several of them are bankrupt.

The bursting of the US housing bubble and resulting financial crisis put significant strain on government fundamentals. 

Aggregate debt to GDP in the US reached 360% at the peak and is still ~350% today.  The household sector and financial sector have deleveraged by a combined 40% of GDP but the govt has increased its leverage by 30% of GDP.  Minimal deleveraging has actually occurred in the US as the public sector has been assuming the liabilities of the private sector.  We have seen this same dynamic across several developed market sovereigns.

The US govt is now running a fiscal deficit of ~8-9%, has debt to GDP (including states but excluding intra-governmental holdings) of 90% and a nominal GDP growth rate that is <3%.  There are no signs that these dynamics are likely to change.

Despite deteriorating fundamentals, US govt rates have continued to decline creating a perception of safety.  The Fed has helped contribute to this dynamic as they have essentially funded 40-50% of the deficit over the past 4yrs+.  Rates are now at levels not seen since the 1940s.

Rising asset prices breed complacency and we are observing that in the US govt bond market today.

We are likely early here which is why we like the long duration options.  However, we are seeing some important signposts on timing. 

In past bubbles, its usually the weakest links (ie lowest quality and most levered business) that crack first.  Often investors think these incidents are isolated because the businesses are lower quality.  In reality, these weak links are often a great signpost that the industry or asset class participating in the bubble is reaching an inflection point.

The weak links today are in peripheral Europe as they have the worst fundamentals and are unable to print.  We have seen Greece, Ireland, Portugal, Spain and Italy crack.  This will spread to the over-levered developed market “printing countries” as well.

Unless the fundamentals for the US govt improve dramatically, valuations are likely to significantly decline as we’ve seen in past bubbles.  The Fed will likely do what it can to prevent rising interest rates given our massive debt burden but there is only so much it can do without causing a loss of confidence in the USD. 

Unless we see a dramatic change in course, UST rates will increase dramatically as a result of inflation created by massive printing, a run on the USD or increasing solvency concerns as the public sector continues to assume private sector liabilities.

Catalyst