RELATIVE-VALUE TRADING IN THE TAXABLE VS. TAX-EXEMPT FIXED-INCOME MARKETS

Transcription

1 RELATIVE-VALUE TRADING IN THE TAXABLE VS. TAX-EXEMPT FIXED-INCOME MARKETS Ms. Hilary Till Premia Capital Management, LLC Chicago, IL March 25,

2 PREMIA CAPITAL MANAGEMENT, LLC PURSUANT TO AN EXEMPTION FROM THE COMMODITY FUTURES TRADING COMMISSION IN CONNECTION WITH ACCOUNTS OF QUALIFIED ELIGIBLE PERSONS, THIS BROCHURE IS NOT REQUIRED TO BE, AND HAS NOT BEEN, FILED WITH THE COMMISSION. THE COMMODITY FUTURES TRADING COMMISSION DOES NOT PASS UPON THE MERITS OF PARTICIPATING IN A TRADING PROGRAM OR UPON THE ADEQUACY OR ACCURACY OF THE COMMODITY TRADING ADVISOR S DISCLOSURE. CONSEQUENTLY, THE COMMODITY FUTURES TRADING COMMISSION HAS NOT REVIEWED OR APPROVED THIS TRADING PROGRAM OR THIS BROCHURE. INVESTMENT IN FUTURES AND OPTIONS PROGRAMS INVOLVES SUBSTANTIAL RISK OF LOSS AND IS NOT SUITABLE FOR ALL INVESTORS. PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS. 2

3 PREMIA CAPITAL MANAGEMENT, LLC Premia Capital Management, LLC s ( Premia Capital s ) services are only available to Qualified Eligible Persons. An investment with Premia Capital is speculative and involves a high degree of risk. Please read the Disclosure Document before seeking Premia Capital s services. The information in this presentation may not be reproduced or used in conjunction with any securities offering and is not for reproduction or distribution without the prior written permission of Premia Capital Management, LLC. Premia Capital may at any time have a position in the trades mentioned in this presentation. 3

4 PREMIA CAPITAL MANAGEMENT, LLC All presentations at this meeting are for informational purposes only and should not be construed as a solicitation. Opinions expressed herein are current opinions as of the date appearing in this material only. No part of this material may be i) copied, photocopied or duplicated in any form, by any means, or ii) redistributed without Premia Capital Management, LLC s prior written consent. The portfolio risk management process includes an effort to monitor and manage risk, but should not be confused with and does not imply low risk. Although the statements of fact in this report have been obtained from and are based upon sources that Premia Capital believes to be reliable, we do not guarantee the accuracy, and any such information may be incomplete or condensed. All opinions and estimates included in this report constitute Premia Capital s judgment as of the date of this report and are subject to change without notice. 4

5 RELATIVE-VALUE TRADING IN THE TAXABLE VS. TAX-EXEMPT MARKETS I. Tactical Strategies II. Long-Term Mean Reversion III. Macro Drivers IV. Risk Management V. Implementation 5

6 I. Tactical Strategies The Seasonal Nature of Redemptions and Issuance $50Bn $40Bn $30Bn $20Bn $10Bn $0Bn -$10Bn -$20Bn Source: Morgan Stanley 6 Jan-97 Mar-97 May-97 Jul-97 Sep-97 Nov-97 Jan-98 Mar-98 May-98 Jul-98 Sep-98 Nov-98 Jan-99 Mar-99 May-99 Jul-99 Sep-99 Nov-99 Jan-00 Mar-00 May-00 Jul-00 Sep-00 Nov-00 Jan-01 Mar-01 May-01 Jul-01 Sep-01 Nov-01 Jan-02 Mar-02 May-02 Jul-02 Sep-02 Redemptions - Issuance Total Redemptions Bond Issuance

7 I. Tactical Strategies (Continued) The Seasonal Nature of Redemptions and Issuance: One View Redemptions - Issuance (97-01) Source: Morgan Stanley 7

8 I. Tactical Strategies (Continued) The Seasonal Nature of Cashflows: A Second View Source: Goldman Sachs 8

9 I. Tactical Strategies (Continued) Example: Year-end 2002 / Early 2003 Despite potentially adverse changes in tax law, note the performance of muni s vs. Treasuries during the yearend period. Source: New York Times (1/12/03) 9

10 II. Long-Term Mean Reversion Long-Term Relationship of the Municipal vs. Treasury Yield Ratio ( ) The Average is 92%... Source: Bloomberg 10

11 II. Mean Reversion (Continued) Relationship of the Municipal vs. Treasury Yield Ratio ( ) But Flight-to-Quality Events Have Led to a Higher Recent Average of 98%. Source: Bloomberg Note current level of this ratio compared to history. 11

12 (Definition of Munratio used in this presentation: II. Mean Reversion (Continued) Source: Bloomberg ) 12

13 II. Mean Reversion (Continued) Recent Cheapness of Muni s Isn t Just With Respect to Treasuries. Source: JP Morgan (11/1/02) 13

14 III. Macro Drivers The Level of Rates Can Be an Important Driver for the Muni vs. Treasury Yield Ratio Source: JP Morgan (11/1/02) 14

15 III. Macro Drivers (Continued) But the Level of Rates Hasn t Always Been an Important Determining Factor Source: Bloomberg 15

16 Flight-to-Quality III. Macro Drivers (Continued) Domestic Risk Aversion: Recently the MOB (Muni s over Bonds) seems to be directly related to the fortunes of the stock market. Source: Bloomberg 16

17 III. Macro Drivers (Continued) Flight-to-Quality Source: Bloomberg Geopolitical Environment: Underperformance of muni s (relative to Treasuries) in December mirrored the rise in gold. This underperformance was reversed in early January when 17

18 III. Macro Drivers (Continued) it appeared that geopolitical risks would be reduced: NORTH KOREA SAYS IT SEES A SOLUTION TO NUCLEAR ROW TOKYO, Jan 9 (Reuters) Source: Bloomberg 18

19 Normal Fluctuations IV. Risk Management Calculate Value-at-Risk based on recent volatility. Source: Bloomberg 19

20 IV. Risk Management (Continued) Event Risk This example portfolio consists of a long Russell 2000 vs. a short S&P 500 futures strategy and a long Municipal vs. a short U.S. Bond futures strategy. These strategies are normally unrelated as illustrated in the graphs on the next slide. 20

21 IV. Risk Management (Continued) Source: Bloomberg 21

22 IV. Risk Management (Continued) But during a scenario test of the portfolio s sensitivity to event risk, we find that the combination of the two trades results in an exposure to a liquidity shock. 22

23 IV. Risk Management (Continued) Event Maximum Loss October 1987 stock market crash -4.11% Gulf War in % Fall 1998 bond market debacle -6.42% Aftermath of 9/11 attacks -3.95% 23

24 IV. Risk Management (Continued) Worst-Case Event Maximum Loss Fall 1998 bond market debacle -6.42% Value-at-Risk based on recent volatilities and correlations 3.67% 24

25 IV. Risk Management (Continued) The short legs of each spread are the more liquid of the pair. So both of these trades are at risk to a flight-to-quality event as happened during the Fall of One response to a concentrated risk to a liquidity shock has been to purchase OTM fixed-income calls. These hedges would cushion the portfolio in the event of another liquidity crisis. 25

26 V. Implementation: Factors to Take into Consideration Municipal Futures Contract A. Duration B. Yield Curve C. Premium / Discount to Index D. Convergence of Futures Contract to Index E. Liquidity Related to Structural Need to Hedge Treasury Bond Futures Contract Trade-Off with Treasury Note Futures Contract 26

27 V. Implementation (Continued) A. Duration Index Underlying December 2002 Municipal Note Index Futures Contract (MBZ2) Average Maturity Date: 02/12/27 Number of Callables: 207/83.8% Avg. First Call Date: 01/10/11 Avg. Premium: Avg. Par Call Date: 01/22/12 Avg. Modified Duration: 7.85 Source: Chicago Board of Trade 27

28 V. Implementation (Continued) A. Duration (Continued) Futures Contract s Index Settlement Uses a 10-Year Pricing Algorithm Simple average yield-to-worst calculated to nearest one-tenth of one basis point Settlement: $100,000 * [5 / r + (1 5 / r) * (1 + r / 200) 20 ] Rounded to nearest 32 nd Source: Chicago Board of Trade 28

29 V. Implementation (Continued) B. Municipal Yield Curve Rate Rising Environment /5 Treasuries Muni's /5 Treasuries Muni's Rate Declining Environment 1/1/95 to 12/31/ /5 Treasuries Muni's In the past, the municipal curve has been stable through rising-rate and declining-rate environments. 1/1/98 to 9/30/ /5 Treasuries Muni's

30 V. Implementation (Continued) B. Municipal Yield Curve (Continued) Yield Curve Rolling quarterly 7/30 yr yield curve Recently the municipal yield curve has steepened by an unprecedented Mar-90 Mar-91 Mar-92 Mar-93 Mar-94 Mar-95 Mar-96 Mar-97 Mar-98 Mar-99 Mar-00 Mar-01 Mar-02 amount (over the last 13 years.) Date 30

31 C. Premium / Discount to Index V. Implementation (Continued) The futures contract trades at a spread to its underlying index,... Source: Bloomberg 31

32 IV. Implementation (Continued) C. Premium / Discount to Index (Continued) which has been market directional. Source: Bloomberg 32

33 V. Implementation (Continued) D. Convergence of Futures Contract to Index Quarterly Cash Settlement; 2:00 p.m. Chicago time on last trading day; FT Interactive Data will evaluate component bond prices & calculate Index value; Bonds > 1 STD from average price change excluded from settlement calculation. Source: Chicago Board of Trade 33

34 V. Implementation (Continued) E. Liquidity Related to Structural Need to Hedge Source: Bloomberg During the recent bull market in bonds, there hasn t been a notable demand for a muni hedging vehicle 34

35 V. Implementation (Continued) E. Liquidity Related to Structural Need to Hedge but during a rising-rate environment, one would expect a renewed need for hedging vehicles with low basis risk, as in

36 V. Implementation (Continued) Treasury Bond Futures Contract Trade-off with the Treasury Note Futures Contract Historically, implementing a MOB trade through the Treasury Bond futures contract has been more consistently profitable than doing so through the Treasury Notes futures contract. 36

37 V. Implementation (Continued) One exception was in early The 10 s vs. 30 s sector of the Treasury curve flattened for the first time since Source: Bloomberg 37

38 V. Implementation (Continued) This occurred in the aftermath of the Treasury department s August 1999 announcement of the decrease in frequency of the 30-year bond auction, boosting the value of the 30-year bond relative to 10- year notes. 38

39 V. Implementation (Continued) A profitable year-end MOB trade had a marginal profit of 9/32 nd s using the Treasury bond futures contract while the same trade implemented through the Treasury note futures contract had a more substantial profit of 62/32 nd s. 39

40 Conclusion There are tactical and long-term investment opportunities in the tax-exempt vs. taxable fixedincome markets which can be implemented through futures contracts, and which historically have been profitable. 40

41 Conclusion (Continued) But there are also a number of risk factors to evaluate before doing so, including: the overall direction of interest rates, and flight-to-quality risk. 41

42 Conclusion (Continued) In deciding upon how to implement a MOB trade, one needs to take into consideration such factors as: the municipal futures contract s spread to its underlying index, and the liquidity of this contract. 42

43 Conclusion (Continued) For the Treasury leg of the trade, one needs to evaluate whether there are unique value considerations in the long-end of the curve before settling upon using the long bond or note futures contracts. 43

44 Source of Graphics (not directly credited in presentation) Slide 1, Statue of Ceres, ancient Roman goddess of the harvest, Chicago Board of Trade. Slide 19, cover of Value at Risk by Philippe Jorion, McGraw Hill, Slide 22, cover of Against the Gods: The Remarkable Story of Risk by Peter Bernstein, John Wiley & Sons, Inc.,

45 CONTACT US Ms. Hilary Till Premia Capital Management, LLC Phone: Fax: