I've been debating whether to post this as much of the early material is basic/intermediate stuff (you should see Harley when he gets going on more advanced tactics, a tour de force in every paragraph!) but in this short little monograph he just keeps building and building and we get to watch someone who is the master of his material, much less of his domain.
note for newer readers: when he refers to the MOVE index, his invention while at Merrill, he is talking about a sentiment indicator for bonds akin to the CBOE's VIX for the S&P 500. Both are derived from prices of options on the underlying
From Harley Bassman, The Convexity Maven, August 22 (charts omitted, available in original):
When making an investment decision in the bond market, there are only three risk vectors to consider:
1) Duration – When one receives their money back;When a bond matures is often used as a proxy for Duration risk, but more precisely it measures the bond’s price sensitivity to interest rate changes.
2) Credit – If one receives their money back;
3) Convexity – How one receives their money back.
Credit risk is rather straight forward; it measures the chance of a default and the loss of one’s investment.Convexity risk is a bit tricky since it is mostly found embedded in callable bonds and can be challenging to measure; but the bottom line is that such bonds (mostly Mortgage and Municipal) presently offer the best relative value.
Duration is neither “good” nor “bad”. It is simply a number that measures how much a bond’s price will move as interest rates shift. For a 1% change in rate (4% to 5%), a six-month bond will see it’s price change by one-half point, a two-year by ~1.85 points, a ten-year by ~8.2 points, and a thirty-year by ~17 points.
While it is often suggested that US Treasuries (USTs) are the safest asset on the planet, duration risk can be quite real. Notice the -alani line- price of the 30yr UST issued near 100 in September 2020 is down nearly 40%. This looks more like a hard equity bear market loss than a safe place to park funds.
Duration is neither “good” nor “bad”. It is simply a number that measures how much a bond’s price will move as interest rates shift. For a 1% change in rate (4% to 5%), a six-month bond will see it’s price change by one-half point, a two- year by ~1.85 points, a ten-year by ~8.2 points, and a thirty-year by ~17 points. While it is often suggested that US Treasuries (USTs) are the safest asset on the planet, duration risk can be quite real. Notice the -alani line- price of the 30yr UST issued near 100 in September 2020 is down nearly 40%. This looks more like a hard equity bear market loss than a safe place to park funds. Source – The Bloomberg
Investors are not risk neutral: The agony of losing a dollar hurts more than the joy of making a dollar. As such, investors typically demand a higher yield to own long-maturity bonds, and thus the Yield Curve is usually positively sloped with longer-maturity bonds yielding substantially more than shorter-maturity bonds. The current -meamata line- Yield Curve is anomalous where six-month USTs yield 5.45%, two-year USTs yield 4.95% and ten-year USTs yield 4.25%.
The 30yr UST presently yields near 4.35% at a price of 97ish; if its rate rose a mere 100bp to 5.35% (still less than the six-month UST), its price would decline by more than 15% to 82ish.
While the case can be made that a recession is near and that interest rates may fall as the Federal Reserve (FED) comes to the rescue with rate cuts, there is little compensation to take duration risk with the Yield Curve so steeply inverted. Credit risk analysis requires a bit of work; which is why most investors rely upon the big-three rating agencies of S&P, Moody’s, and Fitch to do the heavy lifting of estimating the probability an entity will pay off its bonds at maturity.
These ratings range from “AAA” (Microsoft) which means the credit is essentially bullet proof, to “C” (Carvana) where the debtor is highly likely to default. A bond is deemed to be “Investment Grade” (IG) if it is rated “BBB” (Verizon) or better. Exxon is rated “AA” while JPMorgan and Pfizer are examples of credits rated as “A”.The reason there is so much focus on IG is that regulated pension funds may not own bonds that are rated less than BBB (hence the moniker Investment Grade). Investors track -lua’i line- IG credit via the derivatives market where hedgers and speculators can trade a basket of IG bonds at an interest rate spread over the yield of “super safe” USTs. The wider (higher) the spread, the greater the implied risk of a default.
Technically, this is a Credit Default Swap (CDS), a product you may have read about in the press. Functionally, this is the price of a put option on a bond that kicks in if it defaults; and has a high correlation to the SPX and the VIX. The current spread is about 65bps over USTs, a bit below its average. Considering negative economic projections, I would not be adding to an IG position here....
[Climateer here, see how smoothly he shifts into gear? It is on page 6 that he gets to my destination]
....To better understand MBS, think of them as a covered call strategy for bonds, more specifically as a being long a ten-year UST priced at 100 and short a three-year expiry call option struck at 103. I am going to spare you the detailed math, so you just need to trust me....
....MUCH MORE (9 page PDF)
Harley is nothing if not trustworthy. And professional.
...Wall Street loves to make convexity sound complex (I suppose it’s so they can charge higher fees?). We speak Greek (calling it “gamma”), employ physics as a metaphor (analogizing to it “acceleration”), and use mathematical definitions (since it is the second derivative of the asset’s price change)."Pish. Posh." is a technical term only used by market professionals for those situations where one has decided to go full Alinsky rule #5*
Pish, posh. An investment is convex if the payoff is unbalanced for equally opposite outcomes. So if there’s the potential to earn a profit of two on a bet versus a maximum loss of one, the bet is positively convex. If you can lose three versus making two, it is negatively convex. That’s it. The rocket scientists are called upon to help (fairly) price the cost (value) of such possible outcomes. This is why the expansion of derivative trading in the 1990’s resulted in a hiring spree of physics PhD’s....
*#5 Ridicule is man’s most potent weapon. It’s hard to counterattack ridicule, and it infuriates the opposition, which then reacts to your advantage...
The Convexity Maven is nothing if not a professional. Here is part of his mini-bio at MacroVoices:
Harley S. Bassman
Harley Bassman created, marketed and traded a wide variety of derivative and structured products during his twenty-six-year career at Merrill Lynch. In 1985 he created the OPOSSMS mortgage options product that facilitated risk transmission between MBS originators and financial institutions. In 1988, he assumed responsibility for trading and marketing IO/PO and other levered prepayment securities. Soon after this, he started purchasing RTC auctioned MBS Servicing rights and repackaged them for the securities market as BIGS - Beneficial Interests in GNMA Servicing. Later, he started a GNMA servicing conduit becoming one of the Top 20 originators in 1992. As managing and hedging prepayment risk became a priority focus for the financial markets, Mr. Bassman created PRESERV, Merrill's trademarked Prepayment Cap product. Merrill was a leader in this product category writing protection that covered the risk on tens of billions of notional mortgage servicing rights. Later, Mr. Bassman managed Merrill's initial venture into off-balance sheet mortgage trading.
In 1994, Mr. Bassman assumed responsibility for OTC bond options.
Within a year, Merrill was the leader in this product sector. A wide variety of products were offered including vanilla and complex options on MBS spreads and the Treasury yield curve.
To help clients more fully appreciate Volatility as a primary risk vector, he created the MOVE Index. Similar in form to the VIX Index, it is now the recognized standard measure of Interest Rate Volatility.And so much more, all those cutesy Merrill acronyms can be blamed on him and his team.
From 1995 to 2000 he focused on creating hedge strategies for MBS servicers and portfolio optimization techniques for Total Return and Index investors.
Mr. Bassman became the manager of North American MBS and Structured Finance trading in 2001. During his tenure, he created SURF, (Specialty Underwriting and Residential Finance), a self-contained Sub-Prime mortgage conduit. He supervised the issuance of Merrill’s first Sub-Prime securities. He also transitioned the structuring business to a new technology platform....
