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Why Stocks Are Getting Riskier By The Day

Borrowing costs are set to move higher. Higher borrowing costs could force American companies to curtail the debt that they’ve raised to buy back shares of their own stock. Not only would stock prices struggle to move higher if corporations are not buyers of as many shares as they have been in the past, but a lessening in stock buybacks would reduce the perception of corporate profitability. These headwinds to stock valuations as well as future returns – near-term and longer-term – are not easily dismissed. The central bank of the United States (a.k.a. the Federal Reserve) may hike its overnight lending rate in December. Committee members are also discussing plans to phase out the reinvestment of principal on balance sheet securities. Translation? Borrowing costs are set to move higher. The Fed is tightening for the first time in nearly a decade. In so doing, it is implicitly signaling faith in the U.S. economy’s ability to accelerate. The question investors might want to ask is whether or not that conviction is misplaced. For one thing, if the U.S. economy continues to expand at the same sub-par recovery rate of 2.2% per year, stock valuations will move from overvalued to insanely valued. Consider the ratio of total U.S. stock market capitalization to the broadest quantitative measure of U.S. economic activity, gross domestic product (GDP). With total market cap at nearly $21.6 trillion and GDP at at roughly $17.9 trillion, the ratio sits at 120.8%. The historical average since 1970? About 72.5%. Investors should recollect that Warren Buffett described Market-Cap-To-GDP as the “best single measure of where valuations stand at any given moment.” It follows that stocks are more expensive than they were before the financial collapse in 2008, though they are less expensive than they were prior to the tech wreck in 2000. If the ratio reverts to the historical mean of 72.5%? Then hold-n-hope advocates should prepare themselves for stock prices lose HALF of their current value. There are other concerns for investors should the economy prove less resilient than the Federal Reserve would like us to believe. Higher borrowing costs could force American companies to curtail the debt that they’ve raised to buy back shares of their own stock. Why is this so problematic? Not only would stock prices struggle to move higher if corporations are not buyers of as many shares as they have been in the past, but a lessening in stock buybacks would reduce the perception of corporate profitability. Remember, when a public corporation earning $0.70 per share (EPS) has one million shares outstanding, lowering the share count by 10% to 900,000 artificially pushes profitability per share up to $0.778. Were any additional products or services sold? Nope. The accounting wizardly plays itself out in more “reasonable” price-to-earnings (P/E) ratios that investors often use to determine valuation levels. Keep in mind, the buyback game has been happening for more than six-and-a-half years. Since 2009, debt-fueled share buybacks pushed earnings per share up 190%. Revenue from sales of products and services? Sales have increased an exceptionally modest 23%. With buybacks primarily funded by debt, higher borrowing costs sank the debt-funded buyback connection that was part and parcel of the previous market collapse (10/2007-3/2009). Is it unreasonable to suspect that this connection will follow a similar pattern? (click to enlarge) So if the Fed is wrong about the growth of GDP, and if it is wrong about the effect that higher borrowing costs will have on corporate credit expansion, stock valuations will surge. That’s true for Market-Cap-To-GDP. And that’s true for price-to-earnings (P/E). Yet there may also be an issue with the perception of a directional shift from a stimulative environment to a less stimulative one. Take a look at the relationship between the S&P 500 and the Fed’s balance sheet throughout the current bull market run. Each time that the Fed created electronic dollar credits to buy assets, expanded its balance sheet, and subsequently lowered borrowing costs, stocks rallied dramatically. In each of the three instances since the 2009 stock lows where the balance sheet remained the same? Stocks struggled to make meaningful strides. (click to enlarge) The possibility of the Fed reducing its balancing sheet. The danger of share buybacks rolling over. The unlikelihood of the U.S. economy breaking out in dramatic fashion. These headwinds to stock valuations as well as future returns – near-term and longer-term – are not easily dismissed. And that’s not even addressing the possibility that the domestic economy and/or the global economy weaken further. Is the consumer truly in great shape? Retail stocks in the SPDR S&P Retail ETF (NYSEARCA: XRT ) suggest otherwise. The exchange-traded fund hit new 52-week lows below the levels that we witnessed in the August-September sell-off. What’s more, we already know the recessionary struggles associated with manufacturers. Industrial production, which measures the amount of output from the manufacturing, mining, electric and gas industries, has fallen in nine of of the previous 10 months. There are few, if any, ways to put a positive spin on the declines in industrial production. (click to enlarge) And then we have the Fed telling us that “global market risks have diminished.” Really? How much further does copper – the metal with a Ph.D. in economics – need to fall before global market risks reignite? The iPath DJ-UBS Copper Total Return Sub-Index ETN (NYSEARCA: JJC ) has not only broken below August and September lows, it might as well have fallen off a cliff. Similarly, how much further does oil need to drop before oil producing exporters begin falling apart. The iShares MSCI Canada ETF (NYSEARCA: EWC ) is still toiling near its 52-week depths. No Virginia, global market risks have not diminished. For that matter, global economic deceleration is still the prevailing prognostication by the International Monetary Fund (NYSE: IMF ). China’s economic output is decelerating. Japan is already in recession. And European quantitative easing is not stimulating borrowing activity the way that it did in the U.S. In the end, all we have is the collective hope of voting members in the Federal Open Market Committee (FOMC). Hope that economic improvement will overcome lofty valuations and a pullback in corporate borrowing. Don’t get me wrong. Based on everything from “tax-loss harvesting” to “window dressing” to momentum investing, the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) may still represent the best diversified stock holding around. How long one should stick with those brass tacks, however, is another matter entirely. Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.

The Time To Hedge Is Now! November 2015 Update – Part II

Summary Brief overview of the series. Why I hedge. What to do with open positions expiring in January 2016. List of favorite candidates to consider now. Discussion of the risks inherent to this strategy versus not being hedged. Back to November Update Strategy Overview I could not include all the moves and results that I wanted to in the original November Update article due to length, so I am continuing with Part II. For new readers I have not changed the overview or why I hedge sections, so returnees from Part I can skip through those sections to save time. If you are new to this series you will likely find it useful to refer back to the original articles, all of which are listed with links in this instablog . It may be more difficult to follow the logic without reading Parts I, II and IV. In the Part I of this series I provided an overview of a strategy to protect an equity portfolio from heavy losses in a market crash. In Part II, I provided more explanation of how the strategy works and gave the first two candidate companies to choose from as part of a diversified basket using put option contracts. I also provided an explanation of the candidate selection process and an example of how it can help grow both capital and income over the long term. Part III provided a basic tutorial on options. Part IV explained my process for selecting options and Part V explained why I do not use ETFs for hedging. Parts VI through IX primarily provide additional candidates for use in the strategy. Part X explains my rules that guide my exit strategy. All of the above articles include varying views that I consider to be worthy of contemplation regarding possible triggers that could lead to another sizable market correction. I want to make it very clear that I am NOT predicting a market crash. I just like being more cautious at these lofty levels. Bear markets are a part of investing in equities, plain and simple. I like to take some of the pain out of the downside to make it easier to stick to my investing plan: select superior companies that have sustainable advantages, consistently rising dividends and excellent long-term growth prospects. Then I like to hold onto to those investments unless the fundamental reasons for which I bought them in the first place changes. Investing long term works! I just want to reduce the occasional pain inflicted by bear markets. Why I Hedge If the market (and your portfolio) drops by 50 percent, you will need to double your assets from the new lower level just to get back to even. I prefer to avoid such pain. If the market drops by 50 percent and I only lose 20 percent (but keep collecting my dividends all the while) I only need a gain of 25 percent to get back to even. That is much easier than a double. Trust me, I have done it both ways and losing less puts me way ahead of the crowd when the dust settles. I may need a little lead to keep up because I refrain from taking on as much risk as most investors do, but avoiding huge losses and patience are the two main keys to long-term successful investing. If you are not investing long term you are trading. And if you are trading, your investing activities, in my humble opinion, are more akin to gambling. I know. That is what I did when I was young. Once I got that urge out of my system I have done much better. I have fewer huge gains, but have also have eliminated the big losses. It makes a significantly positive difference in the end. A note specifically to those who still think that I am trying to “time the market” or who believe that I am throwing money away with this strategy. I am perfectly comfortable to keep spending 1.5 percent of my portfolio per year for five years, if that is what it takes. Over that five year period I will have paid a total insurance premium of as much as 7.5 percent of my portfolio (approximately 1.5 percent per year average, although my true average is less than one percent). If it takes five years beyond the point at which I began, so be it. The concept of insuring my exposure to risk is not a new concept. If I have to spend 7.5 percent over five years in order to avoid a loss of 30 percent or more I am perfectly comfortable with that. I view insurance, like hedging, as a necessary evil to avoid significant financial setbacks. From my point of view, those who do not hedge are trying to time the market. They intend to sell when the market turns but always buy the dips. While buying the dips is a sound strategy, it does not work well when the “dip” evolves into a full blown bear market. At that point the eternal bull finds himself catching the proverbial rain of falling knives as his/her portfolio tanks. Then panic sets in and the typical investor sells after they have already lost 25 percent or more of the value of their portfolio. This is one of the primary reasons why the typical retail investor underperforms the index. He/she is always trying to time the market. I, too, buy quality stocks on the dips, but I hold for the long term and hedge against disaster with my inexpensive hedging strategy. I do not pretend that mine is the only hedging strategy that will work, but offer it up as one way to take some of the worry out of investing. If you do not choose to use my strategy that is fine, but please find a system to protect your holdings that you like and deploy it soon. I hope that this explanation helps clarify the difference between timing the market and a long-term, buy-and-hold position with a hedging strategy appropriately used only at the high end of a near-record bull market. What to do with Open Positions I want to start out by listing the remaining open positions that will expire in January 2016 and continue to retain some value of more than $0.10 to cover commissions should one consider selling. I will state here that I intend to hold all positions that are below that value as it makes more sense to let them expire worthless than to spend money to close positions. Those contracts that expire worthless, as in the past, are simply the cost of insuring a portfolio against potential loss. Insurance is never free. If the market takes a dive we can come back to reassess those positions if there is value created before expiration. The ask premium listed in the tables below is from when I recommended the purchase. The bid premiums listed are the current premiums available. Investors should do better than the listed prices on both ends but I prefer to use “worst case” examples to make things more believable. First off, I included CarMax (NYSE: KMX ) as it has some positions with value still remaining. Month of purchase Strike Price Ask Premium at purchase Current Bid Premium $ Gain Available per contract Percent Gain Available April $55 $1.85 $2.10 $25 13% May $55 $1.40 $2.10 $70 50% June $57.50 $1.80 $3.20 $140 78% August $55 $3.10 $2.10 -$100 -32% September $50 $1.80 $0.75 -$1.05 -58% I intend to hold onto any of the positions I have in KMX and add contracts with future expirations when the cost is more in line with my strategy guidelines. I did add a position in KMX in October with some April put options with a strike at $40 which are under water and I intend to hold those as a fill position as I wait for better premiums and open interest/volumes on contracts that expire later. Next, we have Marriott International (NASDAQ: MAR ) which has a few contracts that still retain value. Month of purchase Strike Price Ask Premium at purchase Current Bid Premium $ Gain Available per contract Percent Gain Available April $55 $0.80 $0.15 -$65 -81% June $65 $1.75 $1.05 -$70 -40% August $62.50 $1.45 $0.70 -$75 -52% August $60 $1.75 $0.50 -$125 -71% September $62.50 $1.75 $0.70 -$105 -60% I will continue to hold all MAR positions until I have the opportunity to replace the protection with more favorable entry positions with expirations further out. I did add some April MAR put options in October with a strike of $65 which are currently trading at about $2.25 where I originally bought them. I will hold this position. I only have two open positions in Veeco Instruments (NASDAQ: VECO ). Month of purchase Strike Price Ask Premium at purchase Current Last Premium $ Gain Available per contract Percent Gain Available May $20 $0.90 $1.40 $50 55% June $20 $0.40 $1.40 $100 250% I will continue to hold VECO put options as this stock has already fallen from the mid-30 dollar range when I first identified it as a candidate last April to the current price of $19.77 (as of the close on Wednesday, November 18, 2015). There may still be some more gain to capture before the January 2016 expiration. However, these shares have already fallen so much that the strategy will no longer work well for adding new positions in the future. I still hold several positions in L Brands (NYSE: LB ) put options dating back to December. There are six positions listed in previous articles that still have a value of over $0.10. All positions in LB currently show losses. Month of purchase Strike Price Ask Premium at purchase Current Bid Premium $ Gain Available per contract Percent Gain Available April $65.50 $1.10 $0.15 -$95 -86% May $70.50 $1.85 $0.25 -$160 -86% June $72 $1.45 $0.30 -$115 -79% August $70.50 $1.50 $0.25 -$125 -83% August $70.50 $2.20 $0.25 -$195 -87% September $78 $1.80 $0.70 -$85 -47% I intend to continue holding all open positions I have in LB. LB has some premium brands that may suffer during a recession. That is why I believe the stock fared so poorly in the last two recessions. I will continue to use LB in the future. Morgan Stanley (NYSE: MS ) has had mixed results, mostly losses, so far. I have five open January put option positions in MS from previous articles with values above $0.10. I do not own all recommended contracts, but do own some contracts of each candidate listed in my articles. Month of purchase Strike Price Ask Premium at purchase Current Bid Premium $ Gain Available per contract Percent Gain Available May $28 $0.44 $0.15 -$29 -70% June $34 $0.92 $1.27 $35 38% August $35 $0.96 $1.72 $76 79% August $28 $0.71 $0.15 -$56 -79% September $27 $0.62 $0.10 -$52 -84% I also hold an open position from October in the April 2016 MS put options with a strike of $25. I intend to hold all positions in MS and add more in the future. Level 3 Communications (NYSE: LVLT ) was down over 21 percent in August while the S&P 500 fell about ten percent. This is an example of what can happen to the candidates I use. I only have one open position in LVLT with a value remaining of over $0.10. This is another example of the volatility of this stock. Month of purchase Strike Price Ask Premium at purchase Current Bid Premium $ Gain Available per contract Percent Gain Available June $42 $0.90 $0.15 -$75 -83% The LVLT position could be positive again with another market swoon. I will continue to hold my positions in LVLT and intend to continue to use it in the future. The only concern I have with this one is the lack of active trading in the options. I only list a contract that has open interest of more than 50 contracts and prefer more than 100. Many of the LVLT contracts have too few contracts open to consider. Tempur Sealy (NYSE: TPX ) share price continues to surge to near record levels. This is actually good for us in terms of future hedging. I have only three open positions with a remaining value above $0.10. The last price these options traded at is $0.50 but the last bid listed was at $0.25. Month of purchase Strike Price Ask Premium at purchase Current Bid Premium $ Gain Available per contract Percent Gain Available August $60 $1.50 $0.25 -$125 -83% August $60 $1.70 $0.25 -$145 -85% September $60 $1.60 $0.25 -$135 -74% Again, this issue is likely to fall precipitously again when a recession occurs. I will hold my remaining positions and continue to use TPX in the hedging strategy. Royal Caribbean Cruise Lines (NYSE: RCL ) shares have continued to rise and are within about six percent of the high. I have not fared well with these positions yet, but when a recession hits this stock has a tendency to fall fast as consumers put vacation plans on hold or shop for deep discounts. Either one hurts RCL margins. I have only two open positions in January options for RCL that remain above $0.10. Month of purchase Strike Price Ask Premium at purchase Current Bid Premium $ Gain Available per contract Percent Gain Available August $72.50 $1.65 $0.24 -$141 -85% August $70 $1.99 $0.18 -181 -91% I will continue to hold my RCL positions and add more in the future. This is insurance. I remain convinced that RCL will pay off big when we really need it. Coca-Cola Enterprises (NYSE: CCE ) initially fell right after I bought my first position. It had also fallen in previous short-term market corrections by much more than the overall indices. I have only one January option position in CCE open that is valued over $0.10. Month of purchase Strike Price Ask Premium at purchase Current Bid Premium $ Gain Available per contract Percent Gain Available August $45 $1.06 $0.15 -$91 -86% I will hold my CCE positions and add more when the premiums are low enough on future contracts. United Continental (NYSE: UAL ) is one of the weakest remaining major airlines. Its rival, American (NASDAQ: AAL ), is also one to consider if you consider it as a better proxy. Make no mistake that these shares should plummet when a recession hits regardless of the cost of fuel. The shares have been struggling even with low fuel prices. Month of purchase Strike Price Ask Premium at purchase Current Bid Premium $ Gain Available per contract Percent Gain Available September $45 $1.39 $0.31 -$108 -78% I intend to hold my UAL positions and add more in the future. That concludes the summary of outstanding positions expiring in January and what I intend to do with each. List of favorite candidates I listed five candidates with my favorite option contract for each in Part I. E*TRADE Financial (NASDAQ: ETFC ), Goodyear Tire (NASDAQ: GT ), Morgan Stanley , and Royal Caribbean Cruise Lines all have slightly lower premiums available as of the close on Wednesday, November 18, 2015. A couple more day like yesterday and everything will be cheaper. Patience is always a key factor in investing. I start with a new candidate to get things rolling. Boyd Gaming has shown the propensity to fall faster than the overall market, not just in major crashes, but during the brief market declines as well. The share price fell significantly more than the rest of the market during the scares of 2011, 2013 and 2014. It was decimated during 2008-09. It is currently less than three percent off its high of the year and represents a good opportunity for entering a position on this upswing. Another recession could take this issue all the way back down to $5.00 per share. Boyd Gaming (NYSE: BYD ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $20.57 $5.00 $17.00 $0.40 $0.60 1,900 $3,420 0.18% I need three BYD March 2016 put option contracts to provide the indicated protection for a $100,000 portfolio. Masco Corporation (NYSE: MAS ) Current Price Target Price Strike Price Bid Premium Ask Premium Poss. % Gain Tot Est. $ Hedge % Cost of Portfolio $29.84 $15.00 $23.00 $0.20 $0.45 1,678 $3,775 0.225% MAS hit a new 52-week high on Wednesday. Its fortunes are highly correlated with construction and home improvements. A recession could clobber this business. I need five April 2016 put contracts as described above to provide the indicated protection for a $100,000 portfolio. Those are the only new candidates I want to add at this time. As I mentioned earlier in the article, I am hoping to find some more candidates and better entry prices in the future. I will be submitting articles each time I find something worth sharing. Summary As I pointed out in the article linked at the beginning of the precious article I believe that the market is at a crossroads. There is very little impetus to drive prices higher other than cheap money, but cheap money may be enough to keep things going a little longer. If a bear market does not show itself before January 2017 I will be surprised. Many stocks are already experiencing a “stealth” bear market and therefore I believe it is prudent to make prudent hedging decision for 2016. I would like to extend the expirations on contracts more than I have for more extended coverage but the open interest/volume is not yet high enough to wade into those contracts. That should change over the next few months and I will be ready to add more positions as it happens. That is one of the primary reasons why I have tried to emphasize that I am only adding partial positions at this time. That is also why I intend to hold current positions as a means of maintaining protection while we transition to new positions. Going forward I want to write more often about this strategy for two reasons. The first is simply that is seems the global economy is nearly ready to fall into a recession and growth in the U.S. also seems rather stagnant. If profits continue to fall year/year as happened in the third quarter it may portend the beginning of the next recession. Retail sales and profit margins may prove to be the most important measure of the health of the consumer and, by extension, the U.S. economy. The second reason is that I would like to publish whenever I see a good entry point in one of the candidates or when I identify another candidate immediately instead of waiting for a monthly update. I hope these changes will be beneficial to readers following the series. Brief Discussion of Risks If an investor decides to employ this hedge strategy, each individual needs to do some additional due diligence to identify which candidates they wish to use and which contracts are best suited for their respective risk tolerance. I do not always choose the option contract with the highest possible gain or the lowest cost. I should also point out that in many cases I will own several different contracts with different strikes on one company. I do so because as the strike rises the hedge kicks in sooner, but I buy a mix to keep the overall cost down. My goal is to commit approximately two percent (but up to three percent, if necessary) of my portfolio value to this hedge per year. If we need to roll positions before expiration there may be additional costs involved, so I try to hold down costs for each round that is necessary. My expectation is that this represents the last time we should need to roll positions before we see the benefit of this strategy work more fully. We have been fortunate enough this past year to have ample gains to cover our hedge costs for the next year. The previous year we were able to reduce the cost to below one percent due to gains taken. Thus, over the full 20 months since I began writing this series, our total cost to hedge has turned out to be less than one percent. I want to discuss risk for a moment now. Obviously, if the market continues higher beyond January 2016 all of our old January expiration option contracts that we have open could expire worthless. I have never found insurance offered for free. We could lose all of our initial premiums paid plus commissions, except for those gains we have already collected. If I expected that to happen I would not be using the strategy myself. But it is one of the potential outcomes and readers should be aware of it. I have already begun to initiate another round of put options for expiration beyond January 2016, using up to two percent of my portfolio (fully offset this year by realized gains) to hedge for another year. The longer the bulls maintain control of the market the more the insurance is likely to cost me. But I will not be worrying about the next crash. Peace of mind has a cost. I just like to keep it as low as possible. Because of the uncertainty in terms of how much longer this bull market can be sustained and the potential risk versus reward potential of hedging versus not hedging, it is my preference to risk a small percentage of my principal (perhaps as much as two percent per year) to insure against losing a much larger portion of my capital (30 to 50 percent). But this is a decision that each investor needs to make for themselves. I do not commit more than three percent of my portfolio value to an initial hedge strategy position and have never committed more than ten percent to such a strategy in total before a major market downturn has occurred. The ten percent rule may come into play when a bull market continues much longer than expected (like three years instead of 18 months). And when the bull continues for longer than is supported by the fundamentals, the bear that follows is usually deeper than it otherwise would have been. In other words, at this point I would expect the next bear market to be more like the last two, especially if the market continues higher through all of 2016. Anything is possible but if I am right, protecting a portfolio becomes ever more important as the bull market continues. As always, I welcome comments and will try to address any concerns or questions either in the comments section or in a future article as soon as I can. The great thing about Seeking Alpha is that we can agree to disagree and, through respectful discussion, learn from each other’s experience and knowledge.

Want To Trade The Interest Rate Swap/Treasury Bond Spread? Think Twice.

The spread between five-year OTC interest rate swap yields and five-year Treasury yields has recently turned negative. In theory, this spread measures the cost depositors charge for bearing the extra credit risk of bank deposits. Should you buy this spread, expecting a return to positive spreads? Trades based on the yield economics are risky in the very inefficient IRS market. The press has awakened to an unexpected development on the long end of the interest rate swap (“IRS”) yield curve. IRS rates for 5-year maturities and longer are trading below Treasury rates for the same maturities. This spread is, in theory , a measure of the difference between the credit risk of Treasury debt and unsecured wholesale unsecured bank debt of the same maturity. But in reality this spread is obviously vulnerable to divergence from the theory. The chart shows the 5-year swap rate against the 5-year constant maturity Treasury curve over the past six months. A few things stand out. The IRS yield exceeded the Treasury yield during most of the period. The problem, if we should call it that, begins with the early-October run-up in Treasury rates, as displayed in the graph below, produced by FRED, the St. Louis Fed’s database. Several issues that distinguish IRS markets from Treasury markets might have come into play at that point. What are the trading implications of this development? With the listing of 5-year IRS futures by the CME Group (NASDAQ: CME ), it is possible for non-banks to trade the expected spread between 5-year IRS futures (CBOT : F1U) and 5-year Treasury note futures (CBOT : ZF). (click to enlarge) But the negative cash market spread is telling us that an analysis of the credit risk of prime banks is secondary in trading this spread successfully at present. There is no assurance that buying this negative spread will return a quick profit. Economic forces will be secondary determinants of this spread until the OTC IRS itself trades in a secondary market. At the moment, determination of swap rates is the dominion of roughly 20 large banks that face a multitude of other problems. On the other hand, if you meet these conditions: You are a non-bank corporate or financial institutions borrower, but not an IRS dealer. You can finance your operations at interest costs tied to 6-month LIBOR for the foreseeable future. You have a productive use for long-term debt. Run – do not walk – to your nearest swap dealer and pay fixed on an appropriately sized IRS at a negative spread to Treasuries. OTC swap dealers do provide long-term interest cost protection. It will take five or more years for the swap to unwind and provide the cheap long-term cost of money that you seek, but if that is consistent with your business plan, very little can go wrong. [But if there is any chance that you will change your mind (as several municipalities have done), do not enter this transaction. There is no more iron-clad commitment than an IRS. It is not a bond. You can’t buy it back.] The IRS/Treasury spread is a close relative of the TED Spread [difference between the Treasury bill rate and the Eurodollar (LIBOR) rate of the same maturity.] The TED spread is thought to represent the cost to prime London banks of the added credit risk their short term unsecured debt represented relative to that of the U.S. Treasury. In spite of the problematic history of LIBOR pricing, the TED spread has been and will remain, positive. LIBOR is indeed problematic. Within months of the listing of Eurodollar futures (CME : ED), LIBOR became something other than a market yield. London offered the services of the British Bankers Association in polling specified bank employees in London branches to form a poll on LIBOR. This was not good news for believers in market forces. Most readers are aware of the sorry history of this “LIBOR fixing,” with billions in legal settlements of lawsuits resulting from manipulation of this poll on a market price. If you are not familiar with the LIBOR scandal, read here . LIBOR, the interest rate index fundamental to the determination of swap values, is an estimate of the market yield on unsecured wholesale bank debt. These bank debt instruments, London branch deposits, are securities in the same sense that Treasuries are. And nobody questions that they are riskier than the U.S. Treasury bills. But as we learned, the LIBOR rate is not exactly the price at which these deposits are traded. For example if, for some foolish reason, roughly 10 of the 18 banks asked on a daily basis to provide LIBOR, undertook to bring three- and six-month LIBOR rates below the Treasury rates at those maturities, they could make that happen without a single transaction. We learned from the LIBOR scandal that 18 large banks have unfortunate employees that have been cursed with the task of providing an answer to the following imponderable question every day. ICE LIBOR Question: “At what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11 am London time?” There is no compensation this side of $1 billion that would entice me to accept this job. The reason is simple. This person is very likely to be sued, perhaps criminally, and will have no credible economic explanation for the values provided. Consider the plight of this person if employed, for example, to produce Citibank’s (NYSE: C ) rate. Of the 18 banks polled each day, 17 know at what price Citibank could borrow under the (poorly specified) circumstances of the question. The only bank that does not is Citibank, which cannot lend to itself. Worse, none of the 18 banks know the minimum rate at which Citibank could borrow, which is the number requested. Yet this Citibank must make this guess every day. Given the disastrous events of recent years and the legal jeopardy described above, I am sure the LIBOR providers do their very best to guess this rate correctly these days. There is little likelihood that LIBOR is anything other than a very good guess at the 11:00 AM cost of bank money in London. The likelihood of LIBOR falling below the Treasury rate is nil. Why is the IRS rate different from LIBOR? Mostly because it is more obscure. Nobody is going to jail because the spread is out of line right now. But it is no less important to the dealer banks. Various authors search for an economic explanation for an IRS rate less than the Treasury rate. Resist this urge. There is no economic answer. The dominant economic explanation in the press doesn’t wash. This explanation posits that these unseemly low IRS rates are the result of the incredibly safe IRS clearing houses. The argument goes that the new OTC clearing facilities are less credit risky than the U.S. government. This dubious notion, it is suggested, is perhaps due to an implicit government guarantee, resulting from exchanges’ designation as “systemically important utilities.” Such explanations are based on a total misunderstanding of the credit risk associated with entering a swap and could not be more mistaken. IRS trades are credit risky. But the credit risk in question has no direct relationship to the IRS yield. The credit risk exists on both sides of the trade. Each party to the trade is at risk to the other. As a result, there is no reason for either side to pay for the credit risk it creates unless its credit risk is dramatically different from its counterparty. This is not the case for the dealer swap transactions upon which market pricing is based. The heart of the matter is that LIBOR swap rates are based on the dealers’ prices in trades with each other. For the specifics of how IRS prices are determined, l refer the reader to a rather terse explanation from LCH:Clearnet , the largest clearer of IRS globally. The root of the pricing problem is that IRS trades, like LIBOR, are not negotiable and thus inevitably guesses. LCH:Clearnet’s methodology does not specify the guesser. I have no reason to doubt that the effort to guess the market price of IRS is as sincere as that for LIBOR. I expect that the negative value of the Treasury/IRS spread caught the dealer’s attention and that the optics did not amuse them, another reason to believe the prices are close to the market’s transaction prices. Here is a short list of market issues that could be leading to the negative spread. (click to enlarge) Liquidity. As the Chart below indicates, the volume of cleared IRS has been falling steadily for the past two years. This suggests fewer dealer trades. JasonC also shows that U.S. dealer notional principal amounts (NPA) have been falling steadily over the same period, another indicator of falling liquidity in this market. The market may have become less efficient, and the dealers’ ability to change pricing as market conditions change may be reduced. Valuation Issues. An IRS (if you set the credit risk between parties aside) is a zero-sum game. Every dollar one trader earns as IRS rates change is lost by another. Since most IRS are trades between the 10 largest dealers, I cannot imagine that the trading community as a whole benefits directly from unchanging interest rates, whether up or down. The same may not be said of individual dealers of course, so the possibility that one or more specific banks is losing value as interest rates rise is real. But I don’t think one or a few banks losing money would slow the rise in IRS long-term rates. Changing rates do have a substantial and important indirect negative effect on all banks. There is a reporting issue associated with changing rates. Bank derivative risk reporting basically involves two measures of performance. Banks report their derivatives NPA and derivatives net asset value (cash value in the case of a hypothetical sale.) A run-up in interest rates has a substantial effect on every bank’s net asset value. It has no effect on the net asset value of the system as a whole, since every dollar earned in the zero-sum swap market is also lost elsewhere. But regulators base their estimates of the risk exposure of the banks’ swap books on this number. And both negative market values and positive market values rise as rates change. Even an increase in a bank’s swap book net asset value is a negative for bank regulators. This factor could create an incentive to moderate changes in swap rates, especially if there were a substantial probability that these increases would be reversed. The Whack-a-Mole Factor. Finally, I think it would not be surprising if individual banks are as reluctant in the IRS market as they are in the LIBOR market to release estimates of market yields higher or lower than the herd’s reported average. IRS estimated rates are no less subjective than LIBOR rates, since there are no secondary market prices. There has not been a scandal in IRS markets analogous to that in the LIBOR markets. In fact, this is one of the few OTC markets in which there has been no such scandal. But who wants to be first? All in all, I do not find this temporary divergence of IRS rates from their theoretical relationship to Treasury rates very alarming. None of my suggested reasons leads to any kind of financial disaster. But the absence of pricing efficiency in the IRS market is another of the gradually collecting indicators that this market is more expensive to operate and less efficient in performing its risk-transfer function than we should expect. And trading this spread based on bank credit risk estimates is dangerous right now. As presently constituted, the IRS market is hazardous to traders other than dealer banks and their customers. And that is its most important flaw.