Thursday, April 1, 2010

Beware the risk-free return

More silliness on too big to fail (March 5th posting for context) and more on why quants blowup (March 9th posting for context and January 28th and February 28th for some implications).

Sovereign entities are not too big to fail. Default isn’t an absolute. There are a lot of ways sovereign risk can be expressed. Rates are one. The item below touched off a discussion I thought was worth expanding and posting.

“Warren Buffett Safer Than Obama? — By Andy Kroll | Mon Mar. 22, 2010 7:32 AM PDT
Bloomberg News reports today that, according to the bond market, you're safer investing in Warren Buffett than in what used to be the safest of all bets—the US government. The yield on bonds offered by Buffett's storied Berkshire Hathaway last month had a yield that was 3.5 basis points, or 0.035 percent, lower than the US government's Treasury bonds—essentially American debt. Joining Buffett in the safer-than-US-debt category as well were bonds for household names like Proctor and Gamble, Johnson and Johnson, and Lowe's, the home improvement store. "It's a slap upside the head of the government," one financial officer told Bloomberg.
So what's it mean? For one, that the US is selling massive amounts of Treasury bonds—$2.59 trillion since the start of 2009—to borrow money to finance its projects like the stimulus package, bailout, wars in Iraq and Afghanistan, and Obama's other projects. So much money, in fact, that the US will pay 7 percent of revenues to service its debt this year, according to Moody's rating service. According to the Congressional Budget Office, the federal budget proposed by Obama will create record deficits of more than $1 trillion this year and next, and the total deficit between 2011 and 2020 would reach $9.8 trillion, or 5.2 percent of GDP. The US' looming debt crisis is getting so bad and threatening to swallow so much money that Moody's said earlier this month that the US was "substantially" closer to losing its AAA debt rating, the gold standard of bond rating.
From a strictly financial standpoint, the Buffett-Obama comparison highlights just how grim the US' fiscal situation is. It's one thing to borrow deeply to try to create jobs, backstop an ailing housing market, and restart the American economy. But on the morning after the passage of a historic health care bill, the Bloomberg story nonetheless offers a rude awakening as to how deep in debt this country really is.”

I think this exact quote came from . I clicked through to Bloomberg.

Points worth noting are:

First point -- There are ways other than outright default that bond returns can be influenced. That is especially important if the bonds are denominated in other than the bond holder’s native currency. The difference in interest rates between triple ‘A’ corporate bonds and Treasuries may reflect differences portion of each one’s debt that is held by US investors. The portions are probably very different. Consequently, rate differences could reflect differences in the importance of currency bets.

The example cited above is also interesting because the notes mentioned are 2 year notes. The article doesn’t mention the rest of the yield curve. Two year Treasuries are partially driven by liquidity issues, while corporate bond buyers are more likely to intend to hold to maturity. That’s what makes this phenomenon so curious: investments that aren’t as liquid are getting a better interest rate than a more liquid issue. Weird enough to make one suspicious that it also involves perceived downgrade concerns.

There is another interpretation. It could be that the rate differences reflect volatility risk with or without downgrade risk. If traders expect rate volatility while buy-and-hold investors don’t care, then the same things that make Treasuries attractive to traders (i.e., the volume of trading in the secondary markets) would work against them here. (By the way, I know this assumes some non-maximizing behavior on the part of buy-and-hold investors. But, on a two year note, I don’t think it’s an unreasonable hypothesis. But, if that was the entire story, one would think it would be arbitraged away).

It would thus seem that the investor cited in the Bloomberg story is at least partly right. It is probably an expression of differences in the market’s assessment of downgrade-risk. It is unusual for a company in a country to have a rating higher than the country, but not unheard of. I’d also be surprised if there wasn’t an element of currency risk at work also.

Second point -- Governments can change the rules in many ways that influence the return on their bonds other than just by defaulting. Those changes may or may not have an impact on corporate bonds. Governments have used currency controls and currency manipulation, restrictions on capital flows, changing the form of repayment (think gold denominated US bonds in 1933, but the more common form in other countries is changing foreign denominated bonds to local currency at some government-pegged exchange rate).

In fact, some people believe the changes that were made in how inflation is measured are an example of the government intentionally manipulating the payout on TIPS. The government also controls the tax treatment of interest and principal repayment on their debt. Right now the Fed is manipulating the entire yield curve by buying Treasuries. They are manipulating interest rate risk in bond investor terms.

When Bill Gross said sovereign debt now has to be considered more competitive with corporate triple 'A' debt, I don't think he was kidding. This is an example. This example may go away, but I don't think this will be the last time it shows up. It is also quite likely it won’t always be this obvious.

One other aspect of sovereign risk is worth noting although it is not directly relevant to the quote about triple ‘A’ verses Treasuries. Governments have off balance sheet liabilities that make ENRON look like a piker. Defaulting on explicit or implicit guarantees or commitments is a very convenient way for governments to default.

Add in inflation risk and interest rate risk and it doesn’t take a genius to see that a risk-free rate of return is a myth.

Third point -- This one gets away from sovereign risk directly, but relates to the concept of a risk-free rate of return. If one were thinking about a long-short arbitrage trade, there may be a currency issue involved since, as argued above, currency expectations will have a different impact on the two legs of the trade. So, even if one thinks there is no chance of a downgrade, it isn’t a risk-free trade.

This example illustrates an important general point. One only needs an active imagination to generate feasible scenarios that highlight subtle, and sometimes not so subtle, risks embedded in many situations that look like easy arbitrage opportunities. Truly risk-free trades are extremely rare.

Einstein referred to “thought experiments.” These might be considered thought scenarios. It is an amazingly constructive form of daydreaming. Just think up the scenarios and start assigning probabilities to any scenario that will cause the trade to backfire. Next step is to figure a way to hedge away that risk, then repeat the thought scenario exercise. Each hedge introduces new risks that have to be put through the same process. Just in terms of the Treasury to triple ‘A’ example, the currency risk could be any individual currency or a weighted basket where the weights reflect the portions of the debt held by different countries.

A few iterations and a little thought about the costs of the hedges and, bingo, you’ve just backed into an understanding of why quant funds blowup. Imagine backing up these thought scenario exercises with massive databases and computers in order to identify the trades, flag the hedges, quantify the probabilities, and quantify the appropriate size (i.e., cost) of each hedge. Let’s assume all hedges have been correctly identified, the required sizes calculated correctly, probabilities correctly assigned, etc. After all, the quants have the computers, lots of brain power, and data out the whazoo. We’re just daydreaming. They might actually get it right.

But, daydreams of perfect risk-free trades should make one thing clear. They are likely to have multiple “legs” which will increase the cost. It quickly becomes apparent that the margins per “dollar in play” are going to be small. Thus, bigger plays with more leverage are required to justify the effort. So, now in addition to the market risk associated with the trades, the “risk-free” trading system has assumed tremendous leverage risk. Once the issue of leverage is introduced, even with perfect management of the leverage, there is no stable level of leverage at the aggregate level.

The discussion above made the unrealistic assumption that it would be possible to construct the perfect trade. But, much of the intellectual underpinning of modern financial economics has a risk-free cost of capital assumption built in. The first two points should have torpedoed that assumption. So, anyway one looks at it, a risk-free return is a happy fiction. When built into a trading strategy, explicitly or implicitly, it is dangerous.

The issues discussed above are illustrative of a broader issue. The concept of a risk-free rate of return is like a cancer that has invaded modern financial economic theory. Usually, Treasuries Bills are used as a quantitative expression of the mythical risk-free rate of return. Every time “risk-free” appears in a formula or in print, stop! Ask: “What does the author really mean? Are they really saying anything? What concept really should be used? What assumptions have to be made in order for the formula or phrase to make sense?” All sorts of issues get brushed aside through the simple assumption that risk-free returns are an acceptable substitute for addressing some very volatile behaviors.

Finally, some disclosures are in order. I own corporate bonds, but not Berkshires. I have puts on some Treasuries, but not two years. I also own TIPS. The puts are a trade that I am close to closing out. The bond positions are more problematic. Without the puts, I’ll have taken on interest rate risk that I may want to shed.


  1. what do you think of this :

  2. The article addresses an important problem. I intend to address it from a different perspective. Hopefully, next week.