Vineer Bhansali: Negative-Yielding Bonds and Options

In the first installment of my interview with Vineer Bhansali, the author of The Incredible Upside-Down Fixed-Income Market from the CFA Institute Research Foundation, we addressed the underlying implications of negative-yielding bonds, whether they constituted a net negative or positive.

While Bhansali, who is also CIO of LongTail Alpha, eschewed any moral judgments — negative-yielding bonds are neither “good” nor “bad” — he did stress that whatever negative-yielding bonds are, we must adapt to them while understanding that we are now in uncharted territory.

“There is no historical precedent,” he observed. “There’s no theory that you can rely on and say, ‘Hey, by the way, that’s what my professor would have said you should be doing.’”

In the second part of our discussion, we touch on the parallels between negative-yielding bonds and options, anticipate future US Federal Reserve policy, and explore Treasury Inflation-Protected Securities (TIPS), among other related issues. What follows is a lightly edited transcript of our conversation, which took place in late July.

CFA Institute: You write that a negative-yielding bond closely resembles an option. Tell me more about this and where you see opportunities in this “upside-down” fixed-income market, to quote the title of the monograph.

Vineer Bhansali: So that’s probably where my initial conceptual framework started. I’m an options trader. I’ve been trading options for almost 30 years and there are a number of hallmarks of an option when we look at negatively yielding bonds.

One is that you pay a premium that buys you something: It buys you protection against something. That’s one. Second, if nothing happens, then the option value decays. The value of the premium goes to zero, right? So that’s a decay that’s called the time value or decay of that option. And thirdly, an option provides what we call convexity: It provides explosive performance under a specific set of scenarios.

Now think about what a bond is, what a negatively yielding bond is. And we do a very simple example in the book: I talk about a zero-coupon bond that did not exist with a negative yield for a long period of time until recently. But Germany issued one about four or five years ago and now it’s a very big bond. It’s a few billion.

One little digression here: Anything that you want to price in finance has three key inputs: What is your payoff going to be? What is the probability of that payoff? And what is the discount factor to that future payoff? If you know these three things, you pretty much know everything about finance, everything about pricing an instrument. Of these three, the discount factor is the most basic and common to all asset prices.

A pure zero-coupon bond, which is essentially the building block of all of finance because it is part of the discount factor, is the simplest way to take this concept and put it into a simple atomic calculation. So a zero-coupon bond with some maturity gives you 100, or par, at maturity. You pay a certain value today and at maturity, say 10 years on, you get your 100% back, if it’s a non-defaulting government bond. Now, when interest rates are positive, typically you pay less today than the 100 you’ll get at maturity. You’ll pay 90 today and you’ll get 100 in the future, or 80 today and 100 in the future.

If interest rates are negative, the simplest equation of finance is that the price of the zero coupon bond is 1/(1+r)ⁿ or continuously compounded exponential of minus yield times time. If you plug the yield in the time to maturity in that e to the minus yt formula, that is P=e^(-yT), it will tell you that when the yield y is negative, the price today is higher than par. You get 100 in the future, but you pay something more than that 100 today. So the German zero coupon bond was issued at 103.61. So you pay 103.61 today, but you get 100 in the future. That 3.61 that you pay is like an option premium.

So the first measure of why it looks like an option held true: You’re paying a premium to buy this bond and you’ll get less in the future at maturity or “expiry.” And because you’re going to get less in the future, you have a time decay. If nothing happened in the world, that 3.61 will slowly converge down to zero, and you’ll get 100 back. So that is the second feature akin to the option premium time decay.

And thirdly, as we have observed, if something really bad happens, you could get something very valuable in exchange, which is the increased value of that 3.61 premium you paid. Yields can go even further negative, and typically that would happen when there’s fear in the market, so people are thinking of Armageddon. So, you get a lot of convexity as well.

So, now we have all the three hallmarks of an option: Again, you pay a premium, there’s a time decay, and you get convexity. That’s why I call it an option, because it walks like an option, it talks like an option, it looks like an option, it prices like an option.

As a matter of fact, the mathematics of a bond and the mathematics of an option are quite similar as well. So you can use all the theory of optionality and option pricing with these kinds of bonds.

In 2020, the word that dominated discourse was “unprecedented.” In 2021, it is “negative rates” and “inflation.” The Fed is one of the few central banks holding out on cutting rates into negative territory. In the monograph, you pose several questions — and I’m just going read some of these out because I would love to find out the answers: Will it go negative? When and how will that happen? Or will inflation become the next major problem?

Those are exactly the right questions to ask, but they’re kind of the opposite ends of the tails of two distributions.

First let’s talk about negative interest rates. I wrote a couple of Forbes pieces about two years ago saying that in the next crash, the next inevitable thing is for the Fed to go negative because of the force of gravity coming from Europe and Japan, where they are already negative, is flooding the system with money. If there’s a crash, and all this money cannot prop up the markets, the Fed will have no choice but to go negative as well.

And as a matter of fact, short-term interest rates in the US are at zero as we all know, and Treasury bills in the US actually have traded at negative yields already multiple times because when people have to park all this cash in the system for liquidity reasons, they have bought very short-dated bonds with negative yields. At one point about two years ago, we came very close to the Fed having to go negative for such technical reasons, which I guess was one way they might have to actually go negative: The Treasury was issuing bonds at zero, but they were trading in the secondary market at negative yields.

So somebody who could buy from the Treasury in a primary auction, one part of the government, at zero yield could then sell it at a higher price at a negative yield in the secondary market. They could arbitrage the two arms of the government, the Fed versus the Treasury. So at that point, it looked like, if that condition continued, the Fed might have to do something, including possibly taking rates negative so that the arbitrage went away and there was no free wealth transfer for arbitrageurs.

The second way they can go negative in my view is that if you suddenly have a massive asset market melt up, which is related to inflation, and then there’s a catastrophic meltdown, it could result in a negative wealth effect and deflation and a collapse in risky assets. In which case, the Fed might have to do exactly what the Europeans and the Japanese did for other reasons. And we’re not that far away, we’re within one major market crash of them having to go negative.

The second part of your question is inflation, and it’s like the other side of the coin. It’s related to low interest rates globally. Low interest rates globally have resulted in a very significant increase in asset price inflation already.

And in the monograph, again I won’t reveal all the details there, I discuss how asset prices have never been included in inflation metrics, especially the ones that the Fed watches. But we know that those who have assets, i.e., the wealthy, when they buy assets, they hold them, because that provides them security against future needs in capital cash flow.

So over time, if you do not have a market meltdown, that asset price inflation will slowly trickle down into inflation in real stuff, into consumer goods, into food, into hotels, and airlines, and it’s already beginning to happen. Inflation as we all know was growing year over year at 5.5% CPI and 7%-plus PPI in the most recent data releases.

And right now, the big question for the Fed is whether it will last, and they keep saying this word “transitory,” which basically suggests they don’t believe inflation will last. Everybody there is saying transitory. That’s new Fed speak for why they believe it won’t last, and it’s a big bet.

I think the market participants generally believe that inflation is not transitory, and that the risk is that we end up having more inflation than less, because there’s just too much money in the system and asset prices are already very high and they might eventually trickle down into prices of goods and services as well.

Speaking of the Fed, Jerome Powell’s term as chair ends in February, but many people expect him to stay in the job. Do you think he will?

I don’t really know. My guess is yes. And the reason is that, and I wrote a piece on Forbes recently, I call it, “Three Little Birds,” and I talk about lawyers running central banks. One very interesting thing about the three largest central bank heads: Jay Powell, Christine Lagarde, and Haruhiko Kuroda are all lawyers by training, not economists.

And why do I say that? I think he probably should stay in the job because he can manage the system. Congress has a lot of lawyers. Senators are primarily lawyers. And the era that we’re entering now will require not black and white economics, but managing expectations, managing behavior, because the debt load is so high.

I think from a pure economic perspective, there’s absolutely no way that the three large blocs in the world can work off this $25 or $30 trillion worth of negative debt without the government being involved in a big way.

So you need somebody with logical finesse and skill, who can talk with the US Congress and the Senate, with the people who make the laws, so that nobody makes radically dangerous laws right now. A radically dangerous law would be something that says, “We have got to work this debt off in the next three or five years and we have to have a balanced budget.” I don’t think it can happen right now.

So I think he’ll stay in the job. He has a role to fill right now in the world. You have, I don’t know, trillions of dollars as far as you can see that we need for all these infrastructure buildups and so on that are being proposed.

You’ve written a number of articles on Forbes — you’ve mentioned a couple — and one that I saw fairly recently was on TIPS, or Treasury Inflation Protected Securities. TIPS have been in the news recently. So, for those readers who don’t keep a close eye on TIPS, can you just give a snapshot of what’s happening in the market now?

Absolutely! I think the TIPS market is one of the most important markets to watch right now. For those who might not be too familiar, TIPS — Treasury Inflation-Protected Securities — are issued by the federal government. They’re still a relatively small part of the total Treasury issuance and they’re indexed to inflation. The yield that people watch in the TIPS market is the real yield. Just for a reference point, the real yield on the 10-year TIPS is about -1.1%. The yield on the nominal Treasury is about 1.3%.

So you take the difference between the 1.3% and the -1.1%, that’s called the breakeven inflation rate. So 1.3% minus -1.1% is 2.4%. That’s the breakeven inflation.

Now why is that relevant? Because in a world of free bond markets — and I’ve been trading TIPS for 20-something years — the difference between the nominal yield and the real yield, the breakeven rate, is the market’s indication of inflation expectations.

But there’s a number of incredibly smart economists at the Fed and a number of Fed policymakers are incredibly smart market participants, so they understand that in order to manage the inflation expectations, you have to manage this breakeven rate.

Now the Fed is one of the largest participants in the nominal or traditional bond market — participant meaning buyer. They’ve also become one of the largest buyers of the TIPS market. The Fed has gone from being approximately 8% of the market to over 20%. So they own $350-odd billion of TIPS, which is pretty much all the recent supply.

Now why is this important?
Because they are the marginal price setter of both the nominal bond market and
the inflation-linked bond market.

So in order to keep the breakeven at the target 2% inflation rate, which is what they presumably want it to be, slightly higher than 2%, they can either buy more TIPS, which is what they’ve done, and put the real yield at -1.1%, or they can sell nominal bonds, or vice versa.

So the short answer, Lauren, is what’s going on in this market is that the Fed is effectively controlling both the TIPS market and the nominal market to get the breakeven number, inflation expectations, to where they need to be so they can communicate that inflation expectations are anchored. So most market participants don’t trade either the TIPS or the nominal bonds as they would have done, say, 20 or 30 years ago, in the era of the bond vigilantes, when it was a way to discipline policymakers.

Today, the policymakers are the dominant force. They are telling us where these markets should trade. They are setting the prices.

Vineer, your career in the markets has spanned three decades. You survived the global financial crisis (GFC) of 2008 and 2009. You have weathered the brunt of the global pandemic. What long-term scars — if any — do you think COVID-19 will leave on investors of your generation? Are they different from the GFC?

That’s an excellent thing to discuss. I don’t call them scars, I call them a sense of humility. We believe we have the best gadgets and science and computers and this and that, but a minuscule, invisible virus brought the whole system, the whole economy, everything down, right? So I think it was a reset for a lot of us. It gets us to think about how advanced we maybe haven’t become.

COVID-19 put me back into an almost medieval type mindset, that perhaps we’re not as far away from that as we thought, because about a year and a half ago, we didn’t know how to deal with this problem.

And from the point of view of financial markets, which is more my focus, I think a very important bridge has been crossed because of this: The government has become, for better or worse, a permanent fixture in the financial markets.

Paul McCulley, in the book’s Afterword, says it very nicely and I’ll let people read it. I think what market participants will now remember and rely on is the consensus that governments are a part of the markets.

That has never happened in so clear and powerful a form before in my memory. Financial markets no longer just have the purpose of solving problems of economic good and bad. Now they have an incredibly important social problem that they’re implicitly being used to solve. So that’s something that will take some time to get worked off.

So my closing question for you: One of my roles at CFA Institute is to host the Take 15 Podcast, and so I can’t resist asking something I ask every guest — and this is very apropos for you as you trained as a theoretical physicist.

I got the idea after listening to an old episode of This American Life in which John Hodgman conducts an informal survey asking the age-old question: Which is better? The power of flight or the power of invisibility?

So, you have to choose a
superpower, flight or invisibility. Which one do you choose? And what you will
do with it?

Okay, so this is a little bit of a loaded question for me because I’m a pilot. I have about 5,000 hours of flight time in all kinds of aircraft. I love flying and I’ve wanted to fly since I was a little child and so I do fly a lot. So I’m a little biased, and for me that question is actually not that hard. I would always choose flight because of all the joys that it has brought to me. Maybe I’m just biased because I’ve had such a fun experience doing it. It would be fun to try out being invisible. I don’t really know what I would do with it.

What more would I do with flying? There’s so much to see still around the world. If I had more time, I’d probably want to fly around the world.

Well, I wish you many
happy flying hours, and thank you very much for your time today.

Thank you, Lauren. Appreciate it.

For more from Lauren Foster, tune in to the CFA Institute Take 15 Podcast series.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Vineer Bhansali, Ph.D. is the Founder and Chief Investment Officer of LongTail Alpha, LLC, an SEC-registered investment adviser and a CFTC-registered CTA and CPO. Any opinions or views expressed by Dr. Bhansali are solely those of Dr. Bhansali and do not necessarily reflect the opinions or views of LongTail Alpha, LLC or any of its affiliates (collectively, “LongTail Alpha”), or any other associated persons of LongTail Alpha. You should not treat any opinion expressed by Dr. Bhansali as investment advice or as a recommendation to make an investment in any particular investment strategy or investment product. Dr. Bhansali’s opinions and commentaries are based upon information he considers credible, but which may not constitute research by LongTail Alpha. Dr. Bhansali does not warrant the completeness or accuracy of the information upon which his opinions or commentaries are based.

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Lauren Foster

Lauren Foster was a content director on the professional learning team at CFA Institute and host of the Take 15 Podcast. She is the former managing editor of Enterprising Investor and co-lead of CFA Institute’s Women in Investment Management initiative. Lauren spent nearly a decade on staff at the Financial Times as a reporter and editor based in the New York bureau, followed by freelance writing for Barron’s and the FT. Lauren holds a BA in political science from the University of Cape Town, and an MS in journalism from Columbia University.