Tuesday, July 26, 2011

Time to Attempt the Reverse Long Term Capital Management: Long Treasuries/Short Junk? (TLT; TMF; HYG; JNK)

Attempting a 2 1/2 twisting Meriwether, not that high a D-ifficulty score, so to pull it out the execution must be flawless....

...And yes! He sticks the faceplant landing!
Stuff I think about when dreaming up relative value and convergence trades.

LTCM was shorting the more liquid on-the-run treasuries and buying the less liquid off-the-run to catch a few points or shorting treasuries and buying other sovereigns. It worked until Russia defaulted and the crowd did the flight to quality thing: spreads blew out and it was game over.

Here's what Scott Grannis thinks about at Calafia Beach Pundit:
I was probably too cavalier this morning in my dismissal of the risks of a Treasury downgrade. In discussions over lunch today with my most excellent former colleagues, Steve and Ken, I came to appreciate the deep concerns that hover over the institutional bond market community. My point this morning was that a downgrade of US Treasury debt is essentially a downgrade of all debt—since Treasuries are the bedrock upon which all debt is priced—so a downgrade doesn't really mean much.

Their point, however, is that a downgrade of Treasury debt has huge and little-understood implications for many large institutional bond portfolios. To understand why, consider the case of a billion dollar bond portfolio that is currently underweight Treasuries, overweight MBS and corporate bonds, and skewed to lower-quality debt given the steepness of the credit curve. Given the steepness of the yield curve and the still-generous level of corporate spreads, overweighting MBS and corporates has been a very profitable strategy in recent years and promises to continue to be so. Moreover, such a strategy recognizes that Treasuries are very fully valued (and quite possibly overvalued), and thus minimizes a portfolio's exposure to rising Treasury yields. If a manager is even modestly optimistic on the economy's prospects, and if he believes that the Fed's accommodative monetary policy stance should, by making liquidity relatively abundant, result in relatively low default rates and facilitate economic growth, then positioning this portfolio at the low end of his client's acceptable credit quality range makes a lot of sense. (And isn't the Fed trying to encourage people to take on more risk?) In short, there are many good reasons for large, diversified, institutional portfolios to be structured today with a relatively low average credit quality.

But here's the catch: If Treasuries are downgraded, then a portfolio's average credit quality, assuming it holds at least some Treasuries, will fall....MORE
No Noble Laureates were injured in the performance of these mental gymnastics.