What Is a Basis Point Worth?
By Edward Talisse, Chelsea Global Advisors
Originally published on TABB Forum
Ten years ago, no one wanted to inconvenience themselves to try to pick up a few basis points. But today's investors are falling over themselves to collect those very same basis points. Here are 6 risky strategies to combat a flattening yield curve – and why you probably should avoid them.
Ten years ago I started working in Japan as a fixed income sales trader for an international investment bank. I was frequently called upon to travel to other parts of Asia, including Beijing, Hong Kong, Seoul, Singapore and Sydney. My mandate was to invite clients to explore the many money making opportunities available to them by trading the (G4) U.S., German, U.K. or Japanese yield curve.
The touchstone recommendation always seemed to be some combination of going long or short U.S Treasuries and establishing an offsetting position in like maturity German Bunds. Most of our trade ideas were simple variations of a basic mean reversion strategy – optimistic to pick up a few basis points along the way.
After my pitch, I was frequently met by the same incredulous reaction: "Eddie, we are not interested in making a few basis points. ... We want full points, preferably in multiples of 10." No one wanted to inconvenience themselves and stoop down to try to pick up 10, 20 or even 50 basis points! Of course, being in Asia, the clients were always very professional and extremely polite, but my colleagues and I usually left empty handed. We did not win a lot of new business out there.
Back then 10y yields ranged between 4.25% and 5.25% in the U.S., U.K. and Germany and about 1.75% in Japan – so maybe some investors could afford to ignore a few basis points here and there. Well, we have all moved on since 2004 and 10y yields now range between just 0.53% in Japan and 2.72% in the U.K., with the U.S. and German yields sandwiched in the middle. Today's investors are less finicky and are now falling over themselves to collect those very same basis points.
So what do you do when you are now faced with a diminutive and none-too-generous yield curve – and you need income? Here are some (very risky) strategies:
Sell a Tail- increase leverage and borrow on margin; borrowing money to increase long exposure is effectively selling the left tail in a distribution of potential outcomes.
- Sell Volatility- sell options outright and or engage in covered call writing.
- Sell Convexity- or go long instruments like MBS or callable bonds.
- Sell Quality- that is, go long lower rated, more risky instruments, such as High Yield.
- Sell Liquidity- that is, buy highly illiquid instruments like Emerging Market debt denominated in local currency.
- Buy Structured Products- that is doing all of the above in one handy trade.
The concern, in my view, is that all of these alternatives are now almost completely exhausted. Look at a table of Bond Benchmark Performance and you will see that just about every index is near its 52-week low in spread. That means you don't get many basis points (forget about full points!) by engaging in the highly risky strategies numbered above.
As an asset class, risky bonds look, well ... very risky. The upside is measured in basis points, while the downside is measured in points.