Deflation hedges

[Xerxes]

I think like options, these hedges have time premium, and with just couple of years left, that premium has mostly collapsed. Said differently, the downturn needs to be far severe today, to get a homerun, then had it happened say 6 years ago.

[Xerxes]

It would be the ultimate letdown if the deflation hedges don’t produce meaningful results.

[petec]

It would be the ultimate letdown if the deflation hedges don’t produce meaningful results.

 

For the reasons given above, they won’t. Not a cat’s chance in hell they are going to end up in the money so they’re worthless.

[Santayana]

Except that inflation usually happens gradually, but when deflation happens it comes on fast due to a systemic shock.  I don't think they'll pay off, but the way markets are acting, who knows.

[petec]

Except that inflation usually happens gradually, but when deflation happens it comes on fast due to a systemic shock.  I don't think they'll pay off, but the way markets are acting, who knows.

 

Is that right? I’d have thought the other way on. Inflation accelerates like a mad thing when people lose confidence in the value of money and get rid of it as fast as possible, driving velocity up. Deflation I think of as a gradual thing as banks shrink their balance sheets and (all else equal) money supply drops.

[Santayana]

There are hyper-inflationary events, but in general inflation is a slow steady slog.

[StubbleJumper]

Except that inflation usually happens gradually, but when deflation happens it comes on fast due to a systemic shock.  I don't think they'll pay off, but the way markets are acting, who knows.

 

 

Interesting question.  Will the deflation hedges pay off, meaning, "Will they end up in-the-money" at the end of the contract?  I would propose that it is not necessary for the contracts to end up in-the-money, but rather FFH could re-coup a bit of its capital if it can sell the contracts some fearful buyer who is willing to pay for a bit of deflation protection and is prepared to accept the risk that they might not end up in the money. 

 

On this one, how would we define "victory" at this point?  If FFH could sell those contracts for US$50m, would that constitute a "victory" at this stage of the game? What about US$75m, would that be enough to declare victory?  Frankly, if they could sell them for $75m or $100m, I would be happy to have recouped even that much capital....  Even if they could sell half of the protection for $50m, that would recoup a bit of capital and would still leave a large value of notional protection...

 

 

SJ

[Santayana]

Isn't that how they profited on the CDS bet?  it's different in that those were in the money, but I think they realized the value by selling them before expiration.

[StubbleJumper]

Isn't that how they profited on the CDS bet?  it's different in that those were in the money, but I think they realized the value by selling them before expiration.

 

 

Oh, that's definitely how FFH profited from CDS, they definitely did not hold them until expiry.  My musings about the definition of a "victory" are really a question of what kind of offer would FFH need to salvage some useful amount of capital?  I was of the view that the contracts should have been sold 15 months ago when they had a market value of about $25m, but maybe that was hasty?

 

 

SJ

[Xerxes]

Side question :

 

How much of the $40B portfolio can they realistically deploy if they see good names ?

With indiscriminate selling I would think they wouldn’t have to “try to hard” to find investing opportunities like in the past.

 

I understand their need to buyback some of the minority positions, recap the insurance side to take advantage of the hard market and maybe buy back shares with left overs take priority; but all these are being funded through corporate earning. Correct ?

 

 

[petec]

Side question :

 

How much of the $40B portfolio can they realistically deploy if they see good names ?

With indiscriminate selling I would think they wouldn’t have to “try to hard” to find investing opportunities like in the past.

 

I understand their need to buyback some of the minority positions, recap the insurance side to take advantage of the hard market and maybe buy back shares with left overs take priority; but all these are being funded through corporate earning. Correct ?

 

They cannot redeploy a meaningful amount into equities.

 

They can’t recap the subs in any meaningful way and if the equities remain depressed may not be able to grow into a hard market.

 

They certainly don’t have the capacity to grow and buy back stock.

 

The only opportunity is in the bond portfolio - but that could be huge.

[TwoCitiesCapital]

Side question :

 

How much of the $40B portfolio can they realistically deploy if they see good names ?

With indiscriminate selling I would think they wouldn’t have to “try to hard” to find investing opportunities like in the past.

 

I understand their need to buyback some of the minority positions, recap the insurance side to take advantage of the hard market and maybe buy back shares with left overs take priority; but all these are being funded through corporate earning. Correct ?

 

They cannot redeploy a meaningful amount into equities.

 

They can’t recap the subs in any meaningful way and if the equities remain depressed may not be able to grow into a hard market.

 

They certainly don’t have the capacity to grow and buy back stock.

 

The only opportunity is in the bond portfolio - but that could be huge.

 

Yea - if credit spreads explode, they don't necessarily need rates to rise to make decent on the bond portfolio. We're already past the peaks of 2016 and 2018 for the widening of credit spreads.

 

Fingers crossed for 8-10% on high yield and 4-5% on IG corporate. Fairfax is tempting at these prices, but without a meaningful chance to make money on rates we need a larger dislocation to make it up on credit.

[petec]

Fingers crossed for 8-10% on high yield and 4-5% on IG corporate. Fairfax is tempting at these prices, but without a meaningful chance to make money on rates we need a larger dislocation to make it up on credit.

 

That would meaningfully improve the outlook for FFH.

[petec]

TCC which spreads are you seeing being higher than 2016? I’m not seeing that for most of the obvious candidates.

[TwoCitiesCapital]

TCC which spreads are you seeing being higher than 2016? I’m not seeing that for most of the obvious candidates.

 

Just the average spreads on the indices as reported by Bloomberg/Barclays. OAS for HY is over 6.5% at this point. For IG it's over 2%.

 

Both are elevated relative to the highs for both 2015/2016 and in 2018 - of course neither of those last two was an official recession. In 2019, HY spreads were as high ~15% so we could have a ways to go, but I think this will likely be more mild.

 

I'm probably a buyer of high yield bonds in excess of 8% spreads and I imagine Fairfax could put some money to work opportunistically in HY, IG, and preferreds @ that time too

 

 

[Xerxes]

Just to understand what is being explained :

 

Is the opportunity for FFH to liquidate it’s current bond portfolio with a capital gain as yield crater or is the opportunity for them locking at higher rate on corporate bonds due to widening spread ?

 

Or both

[StubbleJumper]

Just to understand what is being explained :

 

Is the opportunity for FFH to liquidate it’s current bond portfolio with a capital gain as yield crater or is the opportunity for them locking at higher rate on corporate bonds due to widening spread ?

 

Or both

 

 

The latter.  The time to reach for yield is when you are paid for the risk.  There's starting to be a bit more reward for risk in the market.

[TwoCitiesCapital]

Just to understand what is being explained :

 

Is the opportunity for FFH to liquidate it’s current bond portfolio with a capital gain as yield crater or is the opportunity for them locking at higher rate on corporate bonds due to widening spread ?

 

Or both

 

 

The latter.  The time to reach for yield is when you are paid for the risk.  There's starting to be a bit more reward for risk in the market.

 

Yea, I'd say both if they hadn't dumped all of their duration back in 2016, but short-term bonds aren't going to go up much - even if the Fed cuts rates to zero. Best case scenario is you get a few percentage points as a one time gain and that's it because yields are back to 0%.

 

The higher credit spreads allow them to sustainably lock in higher yields for the long-term even if interest rates aren't cooperating - this was not an avenue that was available to them a month ago. 

[StubbleJumper]

Just to understand what is being explained :

 

Is the opportunity for FFH to liquidate it’s current bond portfolio with a capital gain as yield crater or is the opportunity for them locking at higher rate on corporate bonds due to widening spread ?

 

Or both

 

 

The latter.  The time to reach for yield is when you are paid for the risk.  There's starting to be a bit more reward for risk in the market.

 

Yea, I'd say both if they hadn't dumped all of their duration back in 2016, but short-term bonds aren't going to go up much - even if the Fed cuts rates to zero. Best case scenario is you get a few percentage points as a one time gain and that's it because yields are back to 0%.

 

The higher credit spreads allow them to sustainably lock in higher yields for the long-term even if interest rates aren't cooperating - this was not an avenue that was available to them a month ago.

 

 

A month ago?  Just last Saturday when I was commenting on the AR I trotted out some silliness about "IMO, this is not the time to reach for yield..."  Here I am five days later noting that maybe it's time to start looking for opportunities to reach for yield!  It has been a hell of a wild week....

 

 

SJ

[petec]

Just to understand what is being explained :

 

Is the opportunity for FFH to liquidate it’s current bond portfolio with a capital gain as yield crater or is the opportunity for them locking at higher rate on corporate bonds due to widening spread ?

 

Or both

 

 

The latter.  The time to reach for yield is when you are paid for the risk.  There's starting to be a bit more reward for risk in the market.

 

Exactly - with the possibility that if spreads compress again when coronavirus turns out not to have killed everyone and when central banks really turn on the taps, they get a nice boost to BV. So it could be both, but one after the other.

[Xerxes]

As a side note given Prem nose for bearishness (notwithstanding his 180 degree in 2017), it would be hard to imagine him not taking advantage of what the virus could mean for equities heading into late February.

 

I am myself am too lazy and slow to buy put options on obvious things like airlines or related industries, but I hope he could squeeze a bit of juice through shorts and puts to add to BK

[petec]

As a side note given Prem nose for bearishness (notwithstanding his 180 degree in 2017), it would be hard to imagine him not taking advantage of what the virus could mean for equities heading into late February.

 

I am myself am too lazy and slow to buy put options on obvious things like airlines or related industries, but I hope he could squeeze a bit of juice through shorts and puts to add to BK

 

There is little space to add to equities, but you might be right that there is space to do a few options. I would guess they are more likely tp go long than short though, at this point.

[wisdom]

They like debt with warrants. You can play both sides that way.

[petec]

They like debt with warrants. You can play both sides that way.

 

Yes, but that’s more something they issue than something that might represent a good opportunity because of a sell off.

[omagh]

Dalio with his thoughts.  To be clear, he is talking his book, so a grain of salt is required.

https://www.linkedin.com/pulse/implications-hitting-hard-0-interest-rate-floor-ray-dalio/?published=t

Long-term interest rates hitting the hard 0% floor means that virtually all asset classes go down because the positive effects of interest rates falling won’t exist (at least not much). Hitting this 0% floor also means that virtually all the reserve country central banks’ interest rate stimulation tools (including cutting rates and yield curve guidance) won’t work. The printing of money and buying of debt assets that central banks are now allowed to buy almost certainly won’t work much (because bonds can’t be pushed much higher and they are also less likely to be sold to buy other assets of entities that are in financial trouble). Further, with this hard 0% interest rate floor, real interest rates will likely rise because there will be disinflation or deflation resulting from lower oil and other commodity prices, economic weakness, and more credit problems. If that plays out in the typical way, rising credit spreads will raise debt service payments to weaker credits at the same time as credit lending shrinks, which will intensify the credit tightening, deflationary pressures, and negative growth forces. God help those countries that have these things and a rising currency, too.