Thursday, December 24, 2009

Betting on Big Rise in Yields?

Henny Sender of the FT reports that top hedge funds bet on big rise in yields:

The recent rise in long-term US interest rates comes as good news for several leading hedge fund managers, including John Paulson, who have positioned their trading books to benefit from higher yields on US Treasury securities.

Mr Paulson, who made big gains earlier this decade by betting against the subprime mortgage market and whose firm, Paulson & Co, manages $33bn, has said he believes that government stimulus efforts would inevitably lead to higher inflation and a corresponding rise in rates.

“It will be difficult for the government to withdraw the economic stimulus,” Mr Paulson said in a speech. “An increase in the monetary base leads to an increase in the money supply, which leads to inflation.”

Bond prices fall as yields rise, and Mr Paulson told the Financial Times last week that he has been hoping to benefit in the Treasury market by buying options that would become profitable if rates headed higher. TPG-Axon’s Dinakar Singh has been making similar options trades, according to a person familiar with the matter.

Julian Robertson, the hedge fund manager, has pursued a related strategy, hoping to benefit from a bigger difference between short-term and long-term interest rates, known as a steeper yield curve, a person familiar with his trades said.

The yield on the 10-year Treasury, which hit a crisis low of 2.055 per cent last year, has moved from 3.2 per cent last month to 3.75 per cent on Tuesday.

Hedge fund managers, however, have been hesitant to engage in short sales of Treasury bonds to profit from the rising yields – and falling prices – because of the Federal Reserve’s heavy involvement in the market. This has led some to buy options – dubbed “high strike receivers” – that would enable them to profit from sharply higher Treasury yields, hedge fund managers say. These trades, which are relatively cheap to execute because they are so out of the money, are based on the thesis that yields could hit 7 or 8 per cent.

“If they are right, and the world ends, they will make a fortune,” said one fund manager who is sceptical of the idea. “If they are wrong, they haven’t lost much.”

Some traders are cautious because many peers lost large sums betting that rates would rise in Japan in the 1990s – as yields fell to less than half a percentage point. The trade was termed the “black widow” because it left so many victims.

“Nobody understood the extent of deflation and economic weakness in Japan,” said Dino Kos of Portales Partners, a research consultancy, who was then a Fed official. “More money was lost on that trade than on any other single trade. Everyone piled in when rates were at 3 per cent and then at 2.5 per cent and then at 2 per cent.”

So is it time to place big bets on rising yields? I could easily see a backup in yields in the near term as economic reports surprise to the upside, but I don't believe that bonds have entered a long-term secular bear market. I think the hedgies are right, best to play interest rate directional calls though options.

Also, given the increase in liability-driven investing by pension funds worried about their funding status, there is an upper cap on bond yields. I don't know what the exact magic number is, but at a certain level (say 7%), you'll have pensions scambling to lock in rates. Bond bears tend to ignore this when predicting doom and gloom on bonds. All they do is focus on the "pending collapse" of the US dollar, which won't happen.

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