Buying Volatility

Buying Volatility: The Instability of Stability
by Eric J. Fry
The Rude Awakening
Wall Street, New York
Tuesday, April 4, 2006

Eric Fry discusses the problems with market stability and how to potentially profit by Buying Volatility.

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Eric Fry, reporting from somewhere along the yield curve...

"There are more values in your hotel mini-bar than in the
U.S. bond market," James Grant joked last week, while
addressing the attendees of the Grant's Spring Investment
Conference in New York. This seasoned, bond-market observer
expressed a similarly bearish viewpoint in the February
24th edition of Grant's Interest Rate Observer.

We are persuaded by Grant's well-reasoned arguments. But
even if we were not so persuaded, we would find the low
price of betting against the bond market difficult to
resist. The prices of credit default swaps (CDS) - the
derivatives that professional investors use to bet on
falling bond prices - have never been cheaper.

This fact alone does not mean investors should be betting
against the bond market, but neither does it mean they
shouldn't be...

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The Instability of Stability
By Eric J. Fry

Stability is Unstable, Jim Grant asserts. "Low volatility
is, ultimately, the source of high volatility," he writes.
"Tranquility emboldens investors, speculators and traders
to take more risk and they would otherwise do. Then
something from the blue – say, a Russian default – shatters
the peace, and the leveraged and overextended operators
trip over themselves trying to raise cash, even those
operators whose resumes include the Nobel Prize in
economics..."

Grant refers, of course, to the meltdown of Long Term
Capital Management, whose payroll included a couple of
Nobel Prize winners. But he also recalls this infamous
event for a more significant reason. Measures of bond
market volatility are as low today as they were in 1998,
immediately prior to the LTCM disaster.

"The Treasury market is as still as a statue," Grant
relates, "If loitering were a crime under the securities
laws, the government yield curve would be under arrest."

Buying Volatility: Unwelcome Tranquility

But Grant does not welcome this tranquility. "The junk-bond
market is a laboratory in the baleful effects of peace and
quiet on the pricing of risk," he explains. "Stability at
very low interest rates is especially dangerous. Just by
reaching for yield, investors encourage more companies to
issue more debt. The higher and more insistent their reach,
the lower the credit quality of the issuance. Before you
know it, the new bond crop is blighted by rising defaults. 
Whereupon, credit spreads widen and CDS prices climb."

Volatility has not departed the financial markets entirely,
as the frenetic recent trading action in the commodities
markets attests, but it has taken a lengthy sabbatical from
most corners of the U.S. bond market.

Narrowing interest rate spreads also testify to the
serenity that has descended upon the bond market. So
fearless are bond market participants that they now accept
near-record-low yields for high-risk bonds.

Credit default swap (CDS) prices have also drifted to
shockingly low levels. CDS are the "default insurance" of
the bond market. When anxiety is high, the price of this
insurance rises. And when anxiety is low – and complacency
is high – the price of insurance falls. Today, CDS prices
are as low as they have ever been. In short, bond investors
fear no evil.

While it is certainly true that volatility may continue to
fall for a while, the odds would seem to favor the opposite
course. "Buying volatility," therefore, would seem a
reasonable risk/reward proposition.

Buying Volatility: Benefiting from Increased Anxiety

"Buying volatility," however, is not simply a bet on mean
reversion, or on mathematical probabilities; it is a hedge
against unforeseen risk. Because volatility expands during
episodes of rising fear or panic, the "owner" of volatility
benefits when anxiety increases. (One never knows what
event might trigger the next anxiety attack in the bond
market, but a bankruptcy by America's largest automaker –
which also happens to be America's largest junk bond issuer
– might make the short list of candidates).

But even if one knew the appointed hour when volatility
would return to the bond market, preparing to profit from
the event is no small matter. Grant advises buying credit-
default swaps (CDS) on a basket of bonds. But he readily
concedes that the average individual investor would "find
it impossible to put on the trade...So we apologize in
advance to the nonprofessionals in the greater Grant's
family."

Do not despair, however, Team Rude will suggest a couple of
approximate substitutes. Several newly minted mutual funds
seek to profit from a drop in bond prices (rise in yield):

Rydex Juno, the granddaddy of short-selling bond funds,
profits whenever the price of the 30-year Treasury bond
falls. As such, Juno can be counted on to prosper during an
all-encompassing rout in the bond market. But since the
greatest excesses in the bond market reside in the
corporate sector – rather than the Treasury sector –
bearish bond investors might wish to focus their attention
on corporate debt securities.

For example, the iShares GS$ InvesTop Corporate Bond Fund
(NYSE: LQD) is an ETF that tracks an index of investment
grade corporate bonds. The bearish investor could either
sell short this ETF or buy long-dated put options on it.

Shimmying farther out onto the crackling branches of risk,
one finds the Flex Bear High Yield Fund (AFBIX), which
provides a direct play on shorting corporate junk bonds.
This open-end mutual fund actually does what Grant advises;
it buys credit-default swaps. Specifically it buys CDS on
the Dow Jones CDX North American High Yield Swap Index.

For the last several years, as junk bond prices have
soared, buying CDS has not been a terrific idea. But in the
less tranquil world that Grant anticipates, they may prove
to be a fine item to own. As Grant points out, "The odds of
an outlying event do not change just because the market is
complacent." Nor do the odds change because the cost of
insurance is very low. Maybe it's time to take out a
policy.

[Joel's Note: Bond market speculators are not the only ones
who suffer when bond prices plummit...so do many
unsuspecting homeowners. If you are a homeowner with an
adjustable rate mortgage, you may be at risk and not even
know it. Since bond prices are inversely correlated with
long-term interest rates, any drop in bond prices would see
a run-up in interest rates that may leave you extended
beyond your means. Interest rates are rising already, which
may explain why the U.S. housing market is cooling off
quickly. Find out how to protect yourself against the next
major drop in home values.

The Hidden Drop – Are You Protected?
http://www.agora-inc.com/reports/DRI/EDRIFB05

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