Wide gyrations yesterday and today in the JGB, Japan's 10-year rates.  Rates volatility is supposedly lower when absolute levels are low, such as in the Cox Ingersoll Rand model...

Some CTA and macro hedge funds had an excellent day yesterday if they were long Japanese rates.  But today will test their profit taking and stop losses rules; probably many will give back yesterday's profits.

Correlation Between S&P500 and 10-yr Tsy: An Ominous Sign?

There is a new peak in the correlation between the S&P500 and the yield on the 10yr Treasury. The bottom graph in the screen shot below is that of rolling 120-day correlations. If we consider 60-day rolling, correlation would be even higher at 84%. It hasn't been as high since late 07 and all of 08. What are markets telling us?...

Factor Analysis of Hedge Funds: The Case of Och-Ziff

Here’s a quick multi-factor analysis of Och-Ziff Overseas II, more precisely of its last 77 monthly NAVs (including May 2010). There are a few interesting take-aways:

• 99% of OZ’s performance, per the Adjusted R-Squared, can be explained by this factor model, which is obviously almost perfect.
• The factors explaining the performance in this model are the S&P 500, the MSCI World index, the Leveraged Loan index, and the Credit Suisse High Yield Bond index.
• The sign of the terms for the S&P 500 and the Leveraged Loan index is negative (with high t-stats. Actually, the t-stats leave no doubt on the significance of the parameters, since they’re all, in absolute terms, above 6.) That is, a significant part of OZ’s returns comes from being SHORT the S&P500, or rather, more probably, by hedging HY bond and global equity positions with shorts/puts on the S&P500.
• Whatever the best explanation for the negative S&P coefficient, this factor analysis indicates that OZ certainly is not a simple levered play on any of these markets.

Note that we cannot draw conclusions from the magnitude of the coefficients since, in this analysis, the NAV of the fund has been normalized to 1 at inception.

SUMMARY OUTPUT

Regression Statistics
Multiple R 0.994780933
R Square 0.989589104
Adjusted R Square 0.989018644
Standard Error 0.019640803
Observations 78

ANOVA
df SS MS F Significance F
Regression 4 2.676752148 0.669188037 1734.721144 1.61407E-71
Residual 73 0.028160565 0.000385761
Total 77 2.704912713

Coefficients Std Error t Stat P-value
Intercept 0.918831919 0.028415423 32.33567607 5.221E-45
MSCI World 0.000880636 9.31751E-05 9.451410452 2.66496E-14
Lev Loan index -0.007563448 0.00059902 -12.6263688 4.89766E-20
CS HY Index 0.001589215 .2593E-05 37.31167533 2.72932E-49
S&P 500 -0.000828656 0.000126406 -6.55550518 6.87152E-09

M&A Feast for Hedge and Private Equity Funds

Here's the ranking of the Top 30 pending M&A deals, ranked by deal size. It will be a hedge and private equity funds feast: not only are they often acquirers (Thomas H. Lee, Apollo, Icahn), but many of the target are among their portfolio companies: Talecris, for example, is owned by Cerberus.

Target	Acquirer	Deal Size (M)		Announced Premium in %	Payment Type	Current Premium in %	Expected Completion Date
XTO ENERGY INC	EXXON MOBIL CORP	41366.82		25.94	Stk	0.05	06/28/10
QWEST COMMUNICATIONS INTL	CENTURYLINK INC	22161.55		12.49	Stk	6.84	06/30/11
SMITH INTERNATIONAL INC	SCHLUMBERGER LTD	12342.48		42.18	Stk	2.22	12/31/10
ALCON INC	NOVARTIS AG-REG	10567.14		-5.99	Stk	-9.31
ALLEGHENY ENERGY INC	FIRSTENERGY CORP	9216.11		36.15	Stk	14.17	04/30/11
MILLIPORE CORP	MERCK KGAA	6805.77		42.48	Cash	0.38	12/31/10
AIRGAS INC	AIR PRODUCTS & CHEMICALS INC	6641.21		27.13	Cash	-3.83	08/13/10
SYBASE INC	SAP AG	5322.65		47.75	Cash	0.73	07/01/10
TALECRIS BIOTHERAPEUTICS	GRIFOLS SA	3890.94		53.45	C&S	22.9	12/31/10
MARINER ENERGY INC	APACHE CORP	3801.5		60.85	C&S	4.38	09/30/10
CONTINENTAL AIRLINES-CLASS B	UAL CORP	3185.64		1.61	Stk	-0.19	12/31/10
PSYCHIATRIC SOLUTIONS INC	UNIVERSAL HEALTH SERVICES-B	3114.41		6.1	Cash	3.04	12/31/10
INTERACTIVE DATA CORP	Multiple	2996.24		1.81	Cash	1.62	09/30/10
BUCKEYE GP HOLDINGS LP	BUCKEYE PARTNERS LP	2720.89		30.42	Stk	6.96	12/31/10
EV3 INC	COVIDIEN PLC	2489.97		19.71	Cash	0.67	07/31/10
MIRANT CORP	RRI ENERGY INC	2273.7		-1.01	Stk	1.52	12/31/10
CASEY'S GENERAL STORES INC	ALIMENTATION COUCHE-TARD -B	1862.09		16.34	Cash	1.15	07/09/10
CYBERSOURCE CORP	VISA INC-CLASS A SHARES	1796.58		40.38	Cash	2.08	12/31/10
GERDAU AMERISTEEL CORP	GERDAU SA-PREF	1607.07		47.5	Cash	0.58
ARENA RESOURCES INC	SANDRIDGE ENERGY INC	1563.56		25.82	C&S	1.74	09/30/10
DYNCORP INTERNATIONAL INC-A	Private (Cerberus)	1472.82		50.21	Cash	0.98	12/31/10
ECLIPSYS CORP	ALLSCRIPTS-MISYS HEALTHCARE	1242.63		20.05	Stk	7.33	12/31/10
RCN CORP	Private	1192.29		38.33	Cash	1.08	12/31/10
AMERICAN ITALIAN PASTA CO-A	RALCORP HOLDINGS INC	1171.62		36.22	Cash	0.36	07/22/10
GLG PARTNERS INC	MAN GROUP PLC	1130.59		42.09	Cash	3.69	09/30/10
INVENTIV HEALTH INC	THOMAS H. LEE PARTNERS LP	1091.03		9.85	Cash	2.04	09/30/10
STANLEY INC	CGI GROUP INC - CL A	1054.64		20.07	Cash	0.54	07/09/10
CKE RESTAURANTS INC	APOLLO GLOBAL MANAGEMENT LLC	1009.5		5.91	Cash	0.32
LIONS GATE ENTERTAINMENT COR	ICAHN ENTERPRISES LP	1001.42		32.6	Cash	-0.92	06/30/10

Deep Discounts on Secondary Market for Hedge Fund Investments

HedgeBay tracks the average haircuts applied to investments in hedge funds resold on the secondary markets. It just reported its latest numbers, and the result is ugly. Whereas positions transacted at a roughly 15% discount last year, the haircut is now about 28%, on average:

Benchmarking Volatility Strategies

The Standard & Poor Volatility Arbitrage index is a interesting benchmark for the different vol arb hedge funds out there. The index measures the performance of a variance swap strategy that consists of receiving the implied variance of the S&P 500 and paying the realized variance of the S&P 500. The rationale behind this strategy is that implied vols tend to exceed realized vol, and it’s been almost always the case for the S&P500:

Despite the sudden spike in realized volatility, the S&P Vol Arb index still outperforms the equity market (S&P500) since inception in 1990. The graph below plots the total return version of the Vol Arb index (SPARBVN, in amber) calculated on a total return (funded) basis, versus the total return on the S&P 500 (with dividend reinvestment) shown in white. Indeed, the Vol Arb index shows that a rule-based variance swap strategy, despite the drop in the Fall of 08, is still far ahead of the return on the S&P500. Moreover, its volatility is clearly much lower.

Owl Creek Overseas Correlation With Equity Markets

The Owl Creek Overseas hedge fund is often presented as uncorrelated to equity markets -- but this is a myth.

On the surface, it looks true: correlation with the S&P500 index, since inception, is 11%, and the linear regression doesn’t even have good explanatory power (t-stat is weak, only 1):

But it you look closely at the above graph, you’ll notice two areas clustered around two diagonals, one in the top left corner and the other around one of the main diagonals. The graph below makes that more clear:

In fact, correlation with the S&P500 has been atrociously high over two distinct periods: from inception to end of December 2007, when correlation was 97%; and from the end of October 08 to present, when correlation has been 92%. Only 10 months of returns are spread out in a random/uncorrelated fashion between the two periods. This shift in correlation regime, to use technical words, created the “Z-shaped” plot of the first graph, which of course fools linear regression and entails an artificially low correlation for the whole period.

(No more posts until CFA is over)

Largest U.S. Hedge Funds, by Assets

BofA/ML published a report today, ranking U.S HFs by AUM as of Jan 1, 2010, in billion dollars. Some of their data are clearly wrong (e.g. Paulson). As shown in the table, some numbers differ significantly from those reported in the March issue of Absolute Return + Alpha, such as Soros, which has $27bn under management according to the magazine.

Name AUM according to BAML AUM according to AR+A
Bridgewater 43.6 43.6
Paulson & Co. 15 (incorrect!) 32 (definitely correct)
King Street 18.5 19
D.E. Shaw & Co. 16.1 23
Och-Ziff 14.4 23
Baupost Not mentioned 21.8
Angelo Gordon Not mentioned 20.8
Farallon Not mentioned 20.7
SAC Capital Advisors 14 12
Highbridge 12.4 17.9
Citadel Investment Group 10.7 12
Renaissance 9.2 15
Tudor 9.2 10
TPG-Axon Capital 8.3 9.6
Soros Fund Management 8.3 27
Viking Global Investors 7.6 11.8

This graph of front-month futures contracts nicely shows the cyclical behavior of this commodity: because production is constant throughout the year but consumption in North American peaks in winter, and because storage costs are significant for natural gas, the forward curve slops upward when stocks are being accumulated, which is in the fall. Once the colder months are passed, the forward curve slops downward.

Ultra Futures Contract

Forgot to say that the new 30-year "Ultra" futures contract is made possible by the recent surge in issuance of 30-year bonds by the Treasury...

A New T-Bond Futures Contract: the Ultra

The T-Bond futures contract we all know has a large range of deliverable securities: all U.S. bonds with remaining terms to maturity of 15 years or more. This made the choice of the CTD (Cheapest To Deliver) quite large and the embedded option quite valuable.

A new contract was launched by the CME Group, the Chicago exchange. The so-called Ultra T-Bond futures takes as deliverable bonds with at least 25 years of remaining term to maturity. This opens the door to quite a few trades and asset-liability management ideas, some of them being detailed on the CME web site: www.cmegroup.com/ultra.

BTW, the code for this new contract is "WN" like "US" is the code for the classic T-Bond futures and "TY" for 10-year contracts. For example, WNH0 refers to the March 2010 Ultra futures contract.

China and India Piling Up on Gold -- So What?

China and India piling up on gold? Sure; their reserves increased 76% and 56%, respectively, YoY, as can be seen below. Yet, their reserves are smalls relative to the rest of the world -- Venezuela had as much gold as India until last year!

Railroad Freight

A good macro-economic indicator: railroad freight carloads. Notice how flat the trend was, with very regular but very short end-of-year drops. The drop since end of 08 is a clear indicator of the recession -- perhaps a leading one?

Best Performing Hedge Fund Strategies This Past Decade

Based on the HFR indices, here are the top hedge fund strategies over the past decade. We can note that converts have had bad years but were top performers on exit of recessions (2002, and 2009). Distressed investing shows a similar pattern (#3 in 01 and 03 and #1 in 2004, then #4 in 2009). Emerging markets have been consistently good performers these past few years, except in 08. Systematic strategies have done very well in the second half of the decade, even in 2007 despite August of that year; of course, last year is an exception due mostly to trend followers.

(click on chart to enlarge. Source: dataforthoughts)

Palladium and Copper Retraced

Palladium and copper came back in line with their linear historical relationship. The palladium contract was at $462 on 1/20, as indicated in the white panel, and as of Friday had lost about $20, while the copper futures had barely budged.

Butterfly Retraced Friday

Here's the same butterfly as of early afternoon Friday. The reason the downside peak we had seen on a previous post does not show up is simply that this chart shows only market-close levels.

Butterfly on 1-Month Options on Mid-Term Swaps

The 50:50 fly on 1-month options on 1-, 2- and 5-year swaps is current 2.7 standard deviations from its 1-year average.

Palladium and Copper

March contracts on palladium and copper at 0.8 std devs from their regression line.

Follow-Up on RYL v. KBH

Since my post of the pair trade long KBH/short RYL, KBH jumped 14.4% from $13.80 to $15.80 while RYL increased 6.8% from $20.50 to $21.90. With a hedge ratio of 0.88, the gain is $2*0.88 - $1.4 = $0.36 per share shorted.

The Lost Decade of Equities - What About Hedge Funds?

The quick study that follows looks at the past decade (from 1/1/00 to 12/31/09), and compares the total returns of a balanced portfolio of classic asset classes with that of a basket of hedge funds. (I used the HFR Weighted Composite Index as a proxy for a well diversified basket of HFs.)

The "classic" portfolio I picked consists of:

• US Large Cap (Total return on the S&P500), with a weight of 30%
• Global Equities (S&P Broad Market Global TR Index), 20%
• U.S. Corporate bonds (JPM U.S. Aggregate Bond TR Index), 20%
• U.S. Government Bonds (Merrill Lynch 10-year U.S. Treasury Futures TR), 20%
• Commodities (Merrill Lynch Commodity Index TR), 10%

The table below shows the values, normalized to begin the decade at 100, of the different asset classes (indices), together with that of the HF index and that of the classic portfolio described above.



On a non-risk-adjusted basis, the basket of HFs does just a bit better than the classic portfolio. We also note that commodities had a phenomenal run, and that equities of all sorts indeed had a lost decade. Now, if we adjust for risk, we can see that the HF index does considerably better. In the graphs below, we add to the classic portfolio a varying dose of the HF index: 0% corresponds to the pure classic portfolio, and 100% is the HF index alone.

The first graph plots annualized returns against standard deviation of monthly returns:



Surprisingly, the HF index beats the portfolio by about 1 p.p., on average, each year, for a much lower volatility. If we look at Maximum Draw Down as another measure of risk, we get the same result:



In conclusion, despite the turmoil of 2008 and 2009, institutional investors will probably (and should) maintain a healthy allocation to hedge funds.

An Indirect Impact of the Housing Burst on the Economy: Through Workforce Immobility

I keep hearing that the low mobility of people between European countries is a challenge to the Euro zone. Now it looks like the U.S. may be suffering from the same issue, due to the extremely poor liquidity of residential real estate.

In a Bloomberg article today: "The ability to relocate for employment, which helped the U.S. recover quickly after previous deep recessions, is the latest victim of the housing bust. About 12.5 percent of Americans moved in the year ended March 2009, the second-lowest ever, estimates Brookings Institution demographer William Frey, after a 60-year record low of 11.9 percent the previous year."

The impact on the economy is not just theoretical. In the same article: "The stagnant workforce may raise the long-term trend rate for unemployment by 1 percentage point and lower economic growth 0.3 percent a year through 2012, said Michael Feroli, an economist in New York for JPMorgan Chase & Co. It has already contributed to keeping the jobless rate as much as 1.5 percentage points higher than would have been suggested by the depth of the recession, Peter Orszag, director of the U.S. Office of Management and Budget, estimated in July."

The Fed Wants To Absorb Excess Reserves -- Quick

The Fed proposed today to sell term deposits, a few weeks after setting up three-party reverse repos. Both are meant to absorb the banks' excess reserves after the largest monetary expansion in U.S. history. That expansion could cause high inflation, which the Fed typically fights by increasing interest rates. But would that work this time?...

Banks hold so much cash that they would still be able to lend to each other at very low rates even if the Fed started to increase its discount rate. To pump so much cash out of the banking system, the Fed seems to realize it has few means, so it began experimenting with the tri-partite reverse repos -- in addition to more traditional tools like the sale of Treasuries, MBS, and now, deposits.

In my view, the Fed acts like admitting their main inflation-fighting weapon (rates increase) would be ineffective if it had to be used today, and that they're running out of time and out of tools to fix that weapon (i.e., to absorb excess reserves).

KB Home and Ryland

The equities of KB Home and Ryland are strongly correlated. Still, market close on Dec 22 was an outlier.



When overlapping the two plots, we see that indeed Ryland suddenly became rich relative to its comp KBH. It was an opportunity to short RYL and go long KBH, with the hedge ratio given by the slope of the regression line above.

Pershing Square and Hovde Fight Over GGP

Two hedge funds, Pershing Square and Hovde, have been arguing over the value of GGP. Ackman claimed today that the GGP (new ticker GGWPQ) are "undervalued against its peers." Comparing the share price with that of Simon Prosperties and Boston Properties do not support his claim, however.

The Fly Already Retraced

Butterfly on 2-, 5- and 10-Year Swaptions

The 1:2:1 fly on 3-month options on the 2-, 5- and 10-year swaps reached levels not seen in 10 years. Definitely a trade to put on.

Spreads on IG Bonds Remain Elevated Relative to Leverage

Morgan Stanley's "2010 Outlook" report shows that, even if spreads on investment-grade bonds have significantly tightened, they remain elevated given the leverage corporations have taken.

USD-Funded Carry Trade: Return of 27%, YTD

Interesting stats that the FXFB page on Bloomberg offers. A simple buy-and-hold strategy of being long the 3 most-yielding currencies of the developed world, in equal weighting, funded by borrowing U.S. dollars, would have returned more than 27% year-to-date this year, with a Sharpe ratio of 1.37. Of course, this is only for the last 12 months, and we know how the Yen carry trade ended... (The actual return is a tad higher since the tool computes the excess return over the risk-free rate.) The screen shot below shows monthly returns and is thus as of Nov 30.

CRE CDOs: Events of Default Triggered on Senior Notes for Missed Interest Payments

On Dec 8 (sorry for the delay!) Standard & Poor's lowered its ratings on 12 classes from LNR CDO V's series 2007-1 (LNR CDO V), which is a commercial real estate collateralized debt obligation. The downgrades "reflect liquidity interruptions to the transaction" after the outstanding classes did not "receive interest according to the trustee
remittance report dated Nov. 23, 2009." The most senior tranches, Classes A and B, are non-deferrable interest classes and they have each missed interest payments, which "resulted in an event of default (EOD) under the transaction's indenture," so S&P lowered the ratings on these classes to "D."

Ironically, the ratings on the 10 subordinate classes were lowered to a relatively higher grade of CC, because the interest due to the classes may be deferred for many years following the EOD. S&P indicated though that they "believe these classes will likely experience principal losses [..] due to principal losses on the underlying commercial mortgage-backed securities collateral."

Smurfit Stone Bond: The Impact of Mutual Funds

We know HY bonds have had a nice run since March this year, mostly due to retail mutual funds. The Smurfit Stone bond pulled up in Bloomberg below is no exception. It is a favorite of credit hedge funds, but its major holders have been U.S. mutual funds ("MF-USA") and insurance companies ("Sch-D")



Looking at historical holdings confirms MFs have been adding to their position on this bond. One fund increased its holding 10x in Q2!

Exxon's Acquisition of XTO...

... simply brought XTO's price in line with its peers. For example, we had noticed on Oct 20 the dislocation w.r.t. Anadarko and suggested a long/short stat arb trade. The long position on XTO pays off about $3/share, and the short position on Anadarko pays about $6/share.

Safeway and Kroger

Safeway and Kroger dropped like a rock after their downgrade by UBS. But Kroger fell more, relatively, than Safeway, resulting in a data point really far from their linear historical relationship (R2 = 72% over past 12 months).

Hedging Corporate Bonds With Other Issuers

Today's post is about hedging corporate bonds with the bonds or CDS of issuers in the same industry, taking paper companies as an example. First up: Smurfit-Stone and International Paper. The two bonds below have slightly different maturities and slightly different coupons, but their prices follow a nicely linear relationship:



The actual relationship may in fact be slightly convex, or simply the bottom left data points, which date back to late 08/early 09, are anomalies due to panicking post-Lehman markets. So the IP bond may be a good hedge, but of course shorting a cash bond is not always easy, so buying CDS protection on IP would be easier if the relationship with the Smurfit bond is robust -- and it is:



The relationship is similar with a comparable bond of another paper company, Temple-Inland:



This makes Temple-Inland another good candidate for hedging the Smurfit bond.

Debt Distribution and the Term Structure of CDS Spreads

Realogy has a massive wall of debt to refinance by 2013:



Not surprisingly, the cost of CDS protection on the firm's debt peaks at that horizon. If the company can pass that milestone (i.e., refinance this debt before it matures), the markets consider the firm will then have an increasing chance to survive:



Same thing with First Data: The firm has a huge revolver maturing in 2014. The bonds maturing in 2015 are not small either ($7bn), but half of it is PIK-able, i.e., its interests can be paid with more debt.

That explains the usual term structure of CDS protection on First Data: it’s most expensive over the next 5 years, when the 2014 revolver matures. Markets seem to think that, if the company can survive that, they should survive longer, so the cost of protection decreases.

CDS Protection on Campbell

In a previous post, we noticed that CDS protection on Campbell Soup is abnormally expensive relative to that of HNZ. It is not consistent with the yield on its debt either: the graph below shows that the yield on similar-maturity debt (in white) has tightened to 2.38% even though the CDS (in amber) kept widening out:



I did some casual research and found out that fundamentals on the company seem pretty good. Below, and except from recent Barclays research:

Campbell Soup Beats Consensus on F1Q and Raises FY Guidance. Despite relatively weak top-line performance partly due to difficult y/y comparisons, Campbell Soup beat consensus expectations for F1Q earnings and raised its full-year earnings and revenue guidance. Campbell 's debt balance stood at $2.905bn, up from $2.624bn last quarter and $2.756bn a year ago. However, the company contributed $260mn to its US pension plan during the quarter. LTM leverage now stands at 1.8x, up from 1.7x last quarter.

Follow Up on the Swaption Fly

The 1:2:1 butterfly on 3-month, 6-m and 12-m options on 1-year swaps did retrace from its low of -27 bpVol on Nov 20 to about -11 bpVol yesterday.

Follow-Up on the VIX

The VIX did continue to drop -- until Dubai scared the markets on Thanksgiving.

Follow-Up on Masco vs Mohawk

The P&L Wednesday would have been 0.263 * (42.40-41.36) + (14.39-14.09) = $0.573 per short share, or equivalently per 0.264 long share. The P&L today is 0.263 * (41.80-41.36) + (14.39-13.70) = $0.80 for the same pair trade.

Consummer (Food) Staples

In this post, we focus on consumer food staple companies: Campbell Soup (CPB, in pink below), HJ Heinz (HNZ, in orange), ConAgra (CAG, green), Sara Lee (SLE, blue) and General Mills (GIS, yellow). We can see that their CDS's tend to be very close, except for GIS in the first half of the year, and for HNZ, which tightened significantly lately. (The graph is normalized in that all time series start at 100.)



Their equities show similar relationships: they're highly correlated, and the stocks of HNZ, GIS and CPG have had the same return since the beginning of the period under consideration. (The graph is normalized again.)



We can notice, among other things, that the divergence of the CDS on Campbell Soup and HJ Heinz is surprising given that their equities have moved in lockstep. If we "zoom" on the companies, we see that indeed the costs of their CDS's are tightly correlated, but that today's market is an outlier:



This would suggest the following trade: go long (sell protection on) Campbell Soup while shorting (buying protection on) Heinz. Of note: CPB has been a favorite short of hedge funds lately, which may have pushed the cost of its protection higher than justified by fundamentals.

Gold Holding by the Gold iShares ETF

The amount of gold held by the gold iShares (shown in amber) has recently increased, but still has caught up with the increase in the value of the ETF shares (in white). The graph is normalized so that both time series start at 100. The bottom graph shows the ratio of the two series; its peak illustrates the fact that the gold reserves of the ETF are low by historical standards -- but of course, the value of that reserve has increased, which is not reflected here.



Another way to look at the same data, since the beginning of the index on Bloomberg. Gold holdings, in weight, increased by almost 20% while shares jumped more than 34%. Gold holdings are in Troy ounces.

Pair Trade: Masco vs Mohawk Industries

Masco and Mohawk Industries have the same credit worthiness, as illustrated by their CDS graphs:



Their stocks are highly correlated, too: the R-squared of the regression is 92%. However, Masco's stock is far (several standard deviations) from the value implied by linear regression, which would be around $11.



In this pair trade, since the slope of the regression line is 0.263, we would be long 0.263 shares of Mohawk for each share of Masco shorted.