Bloomberg News

JPMorgan Clients Roll Bonds as Schwab Options Hedge Default (4)

October 10, 2013

U.S. Treasury Building

A closed sign hangs at the entrance to the U.S. Treasury building in Washington D.C. Concern that a default might happen is starting to show up in the market for short-term obligations of the U.S. Treasury. Photographer: Julia Schmalz/Bloomberg

With the deadline for avoiding a U.S. default looming, investors from Boston to Bangalore are moving to cash, extending the maturities of their short-term Treasury holdings and buying options to help protect themselves should stock and bond prices tumble.

Some JPMorgan Chase & Co. (JPM:US) private bank clients are raising cash while others are dumping Treasury bills with maturities beyond the Oct. 17 debt ceiling deadline for longer-dated bonds. Stewart Capital Advisors LLC in Indiana, Pennsylvania, favors insurance companies, technology stocks and health-care providers, which now have lower valuations. Money is flowing out of an exchange-traded fund that tracks American banks and into overseas equities.

While most investors say a default will be averted, the potential for calamity should political leaders fail to renew U.S. borrowing authority before it runs out is moving some to take measures to safeguard their assets. A Treasury Department report on Oct. 3 said consequences would be “catastrophic” should the U.S. fail to make payments, including higher interest rates, lower investment and slow growth for decades to come.

“We want to protect capital first,” said Kevin Kearns, a fixed-income portfolio manager at Boston-based Loomis Sayles & Co., which manages $188 billion. While Loomis is forecasting that a default will be avoided, the back-and-forth negotiations may provoke some investors to sell assets. “We have our shopping list ready if things go on sale,” Kearns said.

Long Short

Kearns oversees $1.4 billion in a strategy known as long-short, where an investor can speculate on a security’s price either rising or falling. The Standard & Poor’s 500 Index jumped 2.2 percent to 1,692.56 at 4 p.m. in New York.

Stocks rallied as U.S. House Republican leaders embraced a possible short-term deal to avoid default. The lawmakers will present their members with a proposal to raise the debt limit for six weeks without policy conditions, a congressional aide familiar with the matter told Bloomberg News.

The House wants to “offer the president today the ability to move” and ask “for his willingness to sit down and discuss with us a way forward,” Speaker John Boehner said today to reporters.

ETF Moves

Investors withdrew $4 billion from ETFs that track U.S equities between Oct. 3 and 8, data compiled by Bloomberg on fund flows show. At the same time, they added (EFA:US) $418 million to the iShares MSCI EAFE ETF, which buys European, Australian and Israeli shares, the most for any ETF tracked by Bloomberg. The Vanguard FTSE Europe fund (VGK:US) got $385 million, the second most.

Last week, investors withdrew $780 million from the Financial Select Sector SPDR Fund tracking financial companies in the S&P 500, the most since April 2010, according to data compiled by Bloomberg.

Options on the Chicago Board Options Exchange Volatility Index, used to hedge against stock swings, saw record volume of 1.78 million contracts on Oct. 8. Traders bought almost double the number of calls to buy compared with puts to sell that day, data compiled by Bloomberg show. Owning bullish options on the VIX, as the index is known, can offset losses when stocks drop because they become more valuable as price swings widen.

Last Minute

Most investors have yet to become concerned that the debt ceiling will be breached, citing the last-minute resolution of the August 2011 showdown as a model that shows a deal will be achieved in time.

“None of my investors have so far called me to say ‘I want out,’ or ask ‘Is this really a crisis situation?’” Jim Paulsen, the Minneapolis-based chief investment strategist at Wells Capital Management, which oversees about $340 billion, said in a telephone interview. “The American psyche is in much better position today. They don’t look at every issue as Armageddon. It’s just another problem. They are not rushing to gold or U.S. Treasuries or to the dollar.”

About 41 percent of investors in a TD Ameritrade Holding Corp. survey said they haven’t made changes to their investments as a result of the government shutdown that began Oct. 1 or a possible default. Twelve percent said they’re “taking advantage of opportunities,” and 10 percent said they’ve moved into cash in the immediate term, according to the poll of 693 consumers conducted Oct. 3.

Treasury Bills

Concern that a default might happen is starting to show up in the market for short-term obligations of the U.S. Treasury.

Treasury bill rates rose after President Barack Obama rejected calls Oct. 8 to invoke the Constitution’s 14th Amendment to skirt Congressional approval for issuing new debt.

Rates on Treasury bills due on Oct. 17 fell 17 basis points, or 0.17 percentage point, to 0.31 percent at 5 p.m. New York time, according to Bloomberg Bond Trader prices. It touched 0.51 percent earlier, the highest level since they were sold in October 2012. The yield was negative as recently as Sept. 26. The rate on bills maturing on Nov. 14 rose as high as 0.275 percent yesterday, compared with 0.02 percent on Sept. 30. Rates on bills due Nov. 21 rose eight basis points to 0.12 today.

Some investors have been “rolling out those Treasury bills to future maturities” in December and into 2014, Megan McClellan, head of U.S. fixed income at JPMorgan Private Bank in New York, said in a Bloomberg Television interview yesterday. “For people that are nervous, rolling forward is OK, and also going to cash. We have seen, as we saw in 2011, some percentage going to deposits.”

Money Markets

Money-market mutual funds can cope with a short-term default in U.S. Treasuries as long as it doesn’t trigger the kind of investor run that followed the collapse of Lehman Brothers Holdings Inc. in 2008, according to Fitch Ratings.

The funds have high levels of short-term liquidity and have reduced their holdings of Treasuries that would be most immediately affected by the failure of the U.S. to extend its borrowing capacity, the ratings company said yesterday in a report.

“We have avoided maturities in the time period toward the end of October,” Nancy Prior, head of money funds at Boston-based Fidelity Investments, said in an interview. Fidelity is the largest manager of U.S. money funds with $427 billion in assets as of Aug. 31, according to Crane Data LLC in Westborough, Massachusetts.

Corporate Borrowing

The market for corporate borrowing through IOUs expanded to the highest level in eight months as investors turned to alternatives to short-term Treasury bills amid the impasse over raising the U.S. debt ceiling.

The seasonally adjusted amount of U.S. commercial paper outstanding climbed $11 billion to $1.066 trillion in the week ended yesterday, the Federal Reserve said today on its website. That’s the highest level since the market touched $1.085 trillion for the period ended Feb. 13, according to Fed data compiled by Bloomberg.

As Fidelity has sought to avoid Treasury bills maturing near the deadline, Pacific Investment Management Co. has been buying them as their yields have risen, said co-chief investment officer Bill Gross, manager of the world’s largest bond fund at Pacific Management Investment Co.

“Their selling begets opportunistic buying on the part of Pimco,” Gross said in an interview on Bloomberg Television. “We’re picking up pennies on the street. This is a particular penny that we think is risk-free.”

Equities Collars

Hong Kong’s futures and options market operator, Hong Kong Exchanges & Clearing Ltd., increased the discount on Treasury bills used as collateral for margin requirements today, citing concern that the U.S. is at risk of a default.

In Japan, investors sold 2.2 trillion yen ($22.5 billion) of foreign bonds in the week ended Oct. 4, the most on record, according to figures released by the Ministry of Finance in Tokyo. The report didn’t reveal the amount of Treasuries sold by the Japanese bondholders.

For Mark Luschini, chief investment strategist for Janney Montgomery Scott LLC in Philadelphia, the dip in stock prices may become a chance to increase his ownership of U.S. equities.

“Where we are holding significant cash we have been nibbling,” Luschini said in an e-mail response to questions on Oct. 9. He added to his equity positions as the S&P 500 fell to 1,660 and “we will buy more aggressively if we near 1,600, all things being equal.”

VIX Options

Investors who are concerned about a default should use an options strategy known as a collar on their largest or most volatile equity holdings, according to Randy Frederick, managing director of active trading and derivatives at Charles Schwab Corp. in Austin, Texas. To implement the trade, investors buy a put, or option to sell, with an exercise price below the current stock level, financed by selling call options with a higher strike price.

Randall Warren, chief investment officer of Warren Financial Service, purchased options on the VIX as protection against surging stock volatility if the U.S. defaults on its debt.

Warren said he bought calls that become profitable if the VIX rises 12 percent to 22 by Oct. 16, the day before U.S. borrowing authority lapses. He also purchased calls with a 32 strike price for October to protect against bigger swings in the equity market, as well as 22 and 32 contracts that expire in November as a hedge if the talks are extended.

“Buying these options very, very cheaply and getting the explosive upside if something serious does occur with the markets, then that is a way to hedge your bets without a whole lot of money,” Warren, who oversees about $100 million, said in a phone interview from Exton, Pennsylvania.

‘Worst Case’

The S&P 500 has gained 0.7 percent since the U.S. government shut down last week. The VIX slid 0.7 percent to 16.48 over the same period, as a 16 percent tumble today erased an advance to as high as 20.34 on Oct. 8. That compares to a level of 48 when S&P cut the U.S. debt rating in August 2011, the highest since before the bull market started in 2009.

Supreeth S.M., the Bangalore-based chief executive officer at Quant First Asset Advisors India, bought put options on the nation’s CNX Nifty Index stock gauge with an exercise price 10 percent below the index level to protect against the “worst case scenario” of a U.S. default. He’s funding the trade by selling call options on the measure.

“A U.S. default is highly unlikely as we expect lawmakers to come around to avert a disaster,” Supreeth, whose firm manages about $100 million in options, said in a phone interview on Oct. 8. “However, something bad may happen and we are advising clients to hedge.”

Puts with a strike price 10 percent below the Nifty cost 8.2 points more than calls betting on a 10 percent gain on Oct. 8, the least since Sept. 19, one-month implied volatility data compiled by Bloomberg show. The Indian stock index, which has climbed 2 percent this year, tumbled 26 percent in October 2008, the month after Lehman Brothers Holdings Inc. filed for bankruptcy.

Treasury Hedges

UBS Global Asset Management, a money manager that oversees $644 billion, said it has bought Treasury options to hedge against the U.S. defaulting should politicians fail to agree on raising the nation’s debt ceiling.

The company bought two-year Treasury puts and sold those on German two-year note futures to mitigate the risk, according to Brian Fehrenbach, the company’s Chicago-based co-head of U.S. multi-sector fixed income.

“That’s part of our defensive strategy and it’s something we hope will not be tested,” Fehrenbach, a former derivatives trader, said in an interview in London. “The uncertainty in Washington doesn’t promote confidence. The longer they go without a resolution, the more risk there is for a last-minute mistake.”

To contact the reporters on this story: Daniel Kruger in New York at dkruger1@bloomberg.net; Alex Barinka in New York at abarinka2@bloomberg.net

To contact the editors responsible for this story: Lynn Thomasson at lthomasson@bloomberg.net; Dave Liedtka at dliedtka@bloomberg.net


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Companies Mentioned

  • JPM
    (JPMorgan Chase & Co)
    • $55.8 USD
    • 0.24
    • 0.43%
  • EFA
    (iShares MSCI EAFE ETF)
    • $67.47 USD
    • 0.04
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