By Jean-Jacques Ohana, CFA and Dr. Christian Witt. October 25, 2017
On April 21, 2015, legendary bond investor Bill Gross announced via Twitter that German 10-year Bunds constituted « The short of a lifetime. (…) Only question is Timing / ECB QE. » And his timing could have been barely better. Over the next two months, German yields had soared +0.9%. Any investor following his prescient advice would have realized a +7.1% return until yields eventually peaked (about +62.4% annualized). But although yields have resumed their downtrend afterwards, his view has gradually morphed into conventional wisdom. Thus, if German Bunds were « the short of a lifetime » in 2015, are they even more attractive to short today?
From a yield perspective, the issue appears to be a no-brainer. With yields at extreme historical lows (near or below zero), rates can only but rise. Therefore, investors would be crazy to hold on to Bunds and should instead short them as much as possible.
The problem is such a simplistic view ignores opportunity costs. For illustration purposes, have a quick look at Figures 1 to 3. A properly rolled Bund future has more than doubled over the last decade (BBG ticker: SGIXRX Index). Once you ignore the roll yield (BBG ticker: RX1 Comdty), the same Bund future has merely returned +42.1%. The roll yield (+72.6%) accordingly accounts for the vast majority of the total return (+114.7%) of a long position in Bund futures. Also, the roll yield has become even more relevant in the recent past (see Table 1). For each of the three periods we consider, the roll yield exceeded +5.0%. Since a short Bund investor needs to pay the roll yield, opportunity costs are of the utmost importance. As a matter of fact, German Bund yields surged 24 bps since the start of the year 2017, while the rolled price of Bund rose 1.2% instead of falling in synch with rising interest rates.
Breaking down the carry yield gives further valuable insights into the nature of opportunity costs (see Figure 4). The funding yield for one (10-year Bund yield less 3-month Euribor) seems to track the business cycle and monetary policy. This is because short-term policy rates progressively converge towards long-term yields as the business cycle matures. The quality premium (3-month Euribor less average 90-day Repo rate) on the other hand gauges how much investors value the safety of collateral. Accordingly, the premium typically rises to elevated levels during periods of financial turmoil (Lehman: 2008, Euro Crisis: 2010-12, Rise of populism: 2017). A stricter regulatory framework making high-quality collateral generally more valuable may also play a role. The final factor is the roll-down yield (10-year less 9-year Bund yield times duration) which has gradually moved higher over recent years. This factor is more likely linked to expectations of future inflation, central bank purchases of longer-dated bonds or the reluctance of investors to add duration in a low interest rate environment. Given how much policy-related factors interfere with the carry yield, investors should pay close attention to these issues when evaluating their opportunity costs.
But let’s come back to the introductory example. Imagine you had made the maximum possible return by shorting Bund futures (+7.1%) despite a structurally hostile (or negative) carry environment. Do you believe you will be able to continuously repeat this outperformance?
To assess one’s chances of successfully shorting the Bund, we conduct a case study of all major jumps in German yields over the last decade. As Figure 4 demonstrates, the long-term downtrend in German yields led to a continuous deterioration of short Bund positions. However, as yields have been periodically rising, there might have been opportunities to profitably short Bund. We detect five potential opportunities (March to July 2008, August 2010 to April 2011, May to September 2013, April to June 2015, September 2016 to present) and will assume perfect foresight. By « perfect foresight » we mean the investor is capable of precisely timing the trough and subsequent peak in yields. In reality, it is of course doubtful that such a « super-investor » exists.
Unsurprisingly, most of the examined periods have indeed created profitable opportunities to short the Bund (see Table 2). For instance, Bill Gross’ « short of a lifetime » opportunity has created the best return in annualized terms. Meanwhile, continuously shorting the Bund over the full sample period would have resulted in a loss of nearly -39.6%. What is much more striking, is the case of the last case when shorting the Bund proved to be unprofitable despite a rising yields environment, the so called « Reflation » trade. This case stands out for several reasons. One, the yield shock was the least strong one. Two, it is by far the most enduring scenario (407 days and counting). Three, with a roll yield of +0.3%, it has experienced the most hostile carry environment. Four, the average repo spread is the lowest of all scenarios. In a sense, this is like the perfect storm for a Bund bear.
In our opinion, the results highlight the numerous challenges Bund bears must overcome to successfully trade rising yields. If yields move rapid and intense, Bund futures immediately decline. At the same time, the roll yield can be minimized because investors could close out their positions soon. In other words, the duration beta beats carry. But if the move is gradual in nature, the negative carry slowly eats up the gains due to the upward trend in yields. Then, carry beats the duration beta. This effect is reinforced by the ECB’s expansive monetary policy. With short-term interest rates being fixed at -0.40%, every time yields move higher the funding yield and roll-down yield automatically increase the carry until opportunity costs become unbearably elevated. Accordingly, a structural bet against Bunds is self-defeating as long as the ECB maintains historically low and negative interest rates. Today’s market structure therefore forces Bund bears to time the market. This is an incredibly difficult undertaking.
How could a cheaper alternative to market timing look like? Well, investors might try to set up a suitable long-short strategy, say long Italian/short German 10-year bonds. This approach has the advantage of reducing some of the opportunity costs. Remember that the premium related to the quality of collateral is likely linked to flight-to-quality and regulatory considerations. Beyond that, central bank purchases and a reduction of newly issued Bunds hamper the availability of suitable bonds. Unfortunately, this approach requires investors to take a view on the endurance of the Eurozone (see Figure 6). Should they expect the common currency to persist, rising yields would be associated with a converging sovereign spread. Otherwise, Bund yields should decline because insolvent Eurozone sovereigns would make them a safe haven asset once again. Although a bet on the Eurozone’s sustainability is risky, the odds of going long Italian/short German 10-year bonds may be more favorable in today’s carry environment than structurally shorting Bund.
Figure 1: 10-Year Performance of German Bund Excluding and Including Roll Yield (RX1 vs. SGIXRX)
Figure 2: 5-Year Performance of German Bund Excluding and Including Roll Yield (RX1 vs. SGIXRX)
Figure 3: 2-Year Performance of German Bund Excluding and Including Roll Yield (RX1 vs. SGIXRX)
Figure 4: Composition of Carry Yields: Funding, Quality and Roll-Down
Figure 5: Short German Bund Including Roll Yield (SGIXRXS1) and 10-year German Yield (GDBR10)
Figure 6: 10-Year Real Yields for German and Italian Government Bonds
Table 1: Sources of Performance for Long German Bund Position (SGIXRX)
Table 2: Case Study of a Decade of « Short Bund » Scenarios
Published on Riskelia’s Blog