If you’d like a peek inside the mind of a former Yale University math whiz, research assistant for Nobel prize economist Robert Shiller, Goldman Sachs trader, and now New York hedge fund manager, here you go:
Since last November, Jeffrey Talpins has been executing a US Treasury bond ‘auction strategy’ (a.k.a. ‘rate lock’) that most primary dealers (major banks) stopped doing since the financial crisis (mainly because of Dodd-Frank compliance): He shorts Treasury bond ‘WIs’ (holds options to sell soon-to-be-issued Treasury bonds) and then bids for the bonds outright at the Treasury auction to buy them back lower. Element Capital is betting that the Treasury bond (or Treasury note) auction is a ‘bad auction’ (that ‘tails’).
Here’s exactly how this trade works:
When the federal government, the US Treasury, sells Treasury bills, notes, or bonds, it is similar to a stock Initial Public Offering (IPO), however, instead of the investment banks acting as middlemen between the companies and the investing public in an IPO, in every Treasury bond auction, the primary dealer banks are acting as middlemen between the Treasury and the investing public. As per tradition, prior to every Treasury bond auction, the Treasury bond traders are communicating with each other, these days, they are mostly Bloomberg ‘Instant Messaging’ (IMing) each other about that upcoming auction. Treasury bond traders of major Wall Street financial institutions, like the big banks, or ‘primary dealers’, similar to the syndicate of underwriters in an IPO, are required to have skin in the game and bid, known as ‘competitive bidding’, or placing ‘tenders’, in each Treasury bond auction. Treasury bond traders are not only in contact with other Treasury bond traders, but also with their customers, their brokers, or anyone else that could help them get a feel of the market, similar to the ‘cooling off’ period right before every IPO when the syndicate ascertains the interest in the new issue…
At 1PM on the day of the Treasury bond auction, the final details of the auction, is announced. In those details, called the ‘results’, a measure known as the ‘tail’ is calculated. The ‘tail’ is the spread, in basis points (100 basis points equals 1%), between the ‘spot’ price, known as the ’when-issued’ (WI) yield of that newly issued Treasury bond in the trading screens when the results of the auction are announced, and the ‘high yield’, (also called the ‘draw’ price or the ‘stop’). In a single price ‘Dutch’ auction system, the Treasury fills all bids from the highest dollar price / lowest yield down to the lowest dollar price / highest yield until the full amount of the new Treasury bond that is being sold, is raised. The ‘draw price’ or ’high yield’ is the lowest dollar price / highest yield, of the competitive bids, that the Treasury needed to accept to complete the sale of that Treasury bond, and the Treasury allocates the new bonds to those bidders at that same ‘draw price’ / ‘high yield’. Furthermore, from that ‘high yield’, the next lower rate, in eighths (a throwback to 1784 when victorious new world US colonies still without a US Constitution issued government debt and Spanish ‘pieces of eight’ were commonly accepted as currency), becomes the ‘coupon’, or the interest rate of that newly issued Treasury bond that will then start trading on the ‘secondary market’…
Demand is inversely related to the size of the tail, so a ‘tail’ indicates weak demand. The larger the tail, the less demand for the bond. Whenever an auction is said to have tailed, it indicates a lack of demand, and the larger the tail, the “worse” that auction is said to have been. If that Treasury bond auction had a large tail, it is considered to be a “bad” auction (quotes around “worse” & “bad” if using gold-standard mentality). More precisely, the US federal government had a bad auction, because a bad auction means a higher coupon rate was needed to fill the order and sell out the issue. Another way of putting it, a “bad” auction means the US federal government, and by extension, the ‘US taxpayer’, theoretically got taken to the woodshed, and will pay out higher interest payments for the duration of that bond…
A bad auction for the US Treasury, however, is a good auction for the auction participants at the financial institutions that are awarded these bonds after the auction results are announced. The weaker the demand for the bonds, the bigger the tail. The bigger the tail, means how much more the successful bidders (who are ‘assigned’, meaning who have now just bought the bonds at a lower dollar price / higher yield than they previously bid) are ‘in the money’. If that price of the bond assigned to the Treasury bond trader after the auction, if that ’draw price’ / ‘high yield’ is higher than the ’spot’ dollar price / the ’When-Issued’ (WI) yield trading on the screens in the Treasury market at that same time, the more that difference, the larger that tail, the more money the bank makes (interest rates are opposite of price, reverse the two, the ’high yield’ in price, in dollars, or ’32nds’ price, is lower than the spot price in dollars, or ’32nds’ price). The bank then sells the bonds it was assigned, that it just bought, immediately after the auction. That difference, in the ‘high yield’ or ‘draw price’ they are charged for the bonds they were just assigned to, and WI spot prices flashing in the trading screens, that difference, is how much money the bond dealer pockets. How much the bond dealer pockets is how badly the US taxpayer “overpaid” (again, using gold-standard mentality), but the post-gold-standard reality is mixed. The good news is that more dollars will be paid to savers, and the bad news is that future borrowers will be paying slightly higher interest rates.
Any bond trader can execute this trade, but the size of the notional value of Element Capital’s trades have been huge (and recently noted by the Treasury Department). Using leverage, Element Capital has been “the largest bidder in many of the 62 Treasury note and bond auctions between last November and July”. Element’s activity, although not in any violation of rules that limit one buyer to 35% of Treasury notes and bonds sold in any auction, has raised questions because “the cumulative purchases far exceed the hedge fund’s $6 billion in assets under management”. This auction strategy can’t be working out very well for Element Capital these days since the continued worldwide economic weakness, increasing currency wars, the China stock market volatility, and other assorted geopolitical events like Greece, ISIS, refugees, etc., have very few people running from US Treasurys (which would cause a ‘bad auction’). Not to worry though, Element Capital Management LLC is making big money on Forex trades. Jeffrey Talpins was long US Dollars against other currencies and his firm has done very well with that position this year (WSJ Dollar index is up 16% in the past 12 months).
Thanks for reading,
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