Those who have been paying attention to recent events in the hedge fund world would have seen headlines that look similar to the ones below.
You can be forgiven if you are scratching your head wondering how could things go wrong when October was such a good month for most asset classes. Both the S&P 500 and US REITs were up 7%, volatility sank big time which was good for short volatility trades, gold was up 1.5%. Even the long-term US treasuries as represented by TLT were up 2.5%. So what exactly happened. This was also a question I asked myself so I dug deeper. This is what I think happened.
A Primer on Bond Math
Before I can relate what happened, I need to explain what duration risk is because this plays a big role in the story. Duration risk is a measure of the sensitivity of a bond's price to interest rate changes. Duration is the % change in the bond price for every 1% change in the yield-to-maturity (YTM) of the bond. YTM in turn is affected by the changes in the interest rates used to discount future cash flows. Duration is generally higher for bonds with a longer maturity since they have cashflows stretching out further into the future, making them more sensitive to interest rate changes. For example, the current duration of the 2-year US treasuries is about 2 while the duration of the 30-year US treasuries is about 23. This means that the 30-year US treasuries are about 10 times more sensitive to interest rate changes than the 2-year US treasuries. You can read more about duration via the link below.
The Good Old Yield Curve Play
At the Jackson Hole symposium held on 27 Aug 2021, Fed chair Jerome Powell announced that bond purchases can start tapering off in 2021 but there is no rush in hiking rates. Powell also reiterated the belief that recent inflationary pressures were transitory. This led some macro hedge funds to put on short positions on the long end of the yield curve such as the 30-year US treasuries. However, to hedge their bets, they simultaneously put on long positions on the short end such as the 2-year US treasuries. They believe it to be a safe hedge because rate hikes are not happening any time soon. So technically, if yields were to move up uniformly across the curve, the price of the 30-year US treasuries will drop more than the 2-year since the longer-term treasuries have a higher sensitivity to yield movements. The opposite is true if yields were to drop uniformly across the curve.
The "Hedge" in the Hedge Fund
To better protect themselves against the scenario where yields fall across the board, these macro hedge funds need to buy more 2-year US treasuries for every 30-year that they sell. If they want a "perfect" hedge, they will need to buy roughly ten 2-year contracts for every 30-year contract they sell. This would be a good hedge if yields were to move uniformly across the curve but this would mean the upside is capped as well. So obviously, the expectation is for the yield curve to steepen which means that longer-term yields would move up more than the short end of the curve. If this were to happen, the trade would pay off whether the general interest rate went up or down. If interest rates went up, the short 30-year leg would make more than the losses on the 2-year leg. If interest rates went down, the long 2-year leg would make more than the losses on the 30-year leg.
The Benign September
This trade seemed to play out according to script in September as the yield curve steepened by a little.
The 2-year yield increased by 8bps while the 30-year yield increased by 16bps. Theoretically, the hedge funds should make money but this differential is not substantial enough to make really big money.
The Terrible October
The view that inflation was transitory turned out to be wrong as oil prices continued to skyrocket and strong consumer demand continued to exert upward pressure on prices. This led market participants to start to fret that the US Federal Reserve and other central banks would have to raise interest rates more quickly. This led to a sharp increase in yields on the short end of the curve as markets began to price in this possibility. At the same time, yields at the long end began to come down as markets worried that prolonged inflationary pressures would adversely affect the economy. Hence, the yield curve flattened substantially.
The 2-year yield increased by 20bps while the 30-year yield reversed course and dropped 15bps. This led to the worst possible outcome for any spread trade. Both legs are losing at the same time. The long 2-year leg lost further from the spike in yields and this is made worse by the 10 times leverage employed. The short 30-year leg also lost from the drop in yields at the long end.
The Curse of a Spread Trade
Below is the comparative price movement of the 2-year and 30-year US treasury futures over the past two months.
You can see that for most of the period before the middle of October, the 10x levered 2-year leg moved pretty much in line with the 30-year leg. This is a testament to the correct hedge ratio being used to match the duration risk for the 2-year and the 30-year. Hence, we can expect this trade to be P&L neutral for uniform yield changes across the board. However, things fell apart after the middle of October as the yield curve flattened. The price movement diverged, causing massive damage to the books of these macro hedge funds. The extent of the damage depends on how much of the entire portfolio was put into this trade.
The irony is that if there was no attempt to match the duration risk by leveraging up the 2-year leg, this trade would still have been profitable at the end of October. But of course, that would mean that the 2-year leg would not be a "perfect" hedge in the event of a general fall in interest rates. In any case, I hope I've shed some light on this episode in October.