Boaz Weinstein, Bond Liquidity and Chess

Creditflux reports that Boas Weinstein’s Saba Capital Master Fund lost 2.8% in October, bringing year to date losses to 6.8%, according to media reports. The fund’s relatively disappointing performance since July 2012 had been linked to central bank intervention dampening volatility, but when volatility returned to the market in October the fund suffered its worst monthly performance since January. A loss of 6.8% would equal last year’s performance for the fund, while 2012 saw the fund lose 3.9%.

I’m not particularly concerned about this drawdown because I’m comfortable with Boaz Weinstein’s ability to adapt—he’s been at it this for a while, and he’s money good after netting out wins to losses. He’s a chess player and a pretty good one, 2100-2200s level. Games of strategy and the ability to navigate them well are a decided advantage in credit markets.

With stocks, you square up against the market, as there nearly always the presumption of complete liquidity. In credit markets, you line up against a counterparty on the other side of an illiquid trade. In credit markets, sell-side traders often sit at their desks from 8 in the morning until 4:30 waiting for a client to call. Often there isn’t a single customer trade all day. Even the most liquid US corporate bond trades in size only a handful of times a day.

Inter-day price quotes for credit are not meaningful data points: the focal point is the bid at that instant against that ask at that instant. While there is more liquidity than there was 20 years ago given active bond and loan trading, credit derivatives, and the creation of multiple kinds of credit-connected investment vehicles, corporate bonds do not tick up and down minute by minute like big cap stocks (btw, there is much less trading than there was 5 years ago). There never was that much liquidity ever in credit. Assuming continuous streaming quotes is nothing more than a fantasy. In its place is strategic positioning, and something analogous to tempo in chess.

I wanted to see if there anything to be known about him from his play. Here is my commentary on one of his games. I had the feeling I could read something from it, and I wasn’t disappointed.

He played black, opening with the Max Lange Attack. Max Lange is old fashioned. This off-the-beaten-path opening indicates an understanding of the literature for an appropriate attacking line against an aggressive white opening. It is a line, old-fashioned or not, that suits his temperament. It has no connection to hypermodern thinking that cedes the center to white only to attack form the flanks well into the game. Weinstein’s game here is played in confrontational style; it enables pawns to entrench well into the center right next to white’s encampment. In fact the way Weinstein played, the Max Lange was explicitly antagonistic because he threw in the scotch gambit, a way to give up a piece only to storm back later in the game at an advantage (see board).

Weinstein’s mid-game looked even in pieces and I didn’t see glaring imbalance positionally speaking. This is shows a very calculated tendency that puts a value on balance. The end-game felt staid and lacking in tempo, with no fireworks. Judging merely by that one game, I think Weinstein will always do great on white—I’d really like to see him play out-for-blood openings like the four pawns attack. But in when he is placed in complicated situations that have no clear line of attack, the subtly demanded (think cautiously attacking from the flank a la Grunfeld) would put him at a disadvantage. One game makes it impossible to know how handicapped he would be.

In the hedge fund space, Weinstein is still a star and no clown, and if you are reading this it is likely you know this. Weinstein was promoted at age 27 to become Deutsche Bank’s youngest ever Managing Director. He had a good $10 billion P&L run over 12 years, but booked a massive $1.8 billion prop trading loss in 2009. After this loss, he started his own credit-focused hedge fund called Saba (“Grandfatherly Wisdom”?) Capital Management, based in New York. Weinstein does have a tendency to dabble in complicated, hard-to-crack puzzles… Saba has a "Tail Hedge fund," which aims to protect assets against rare and unexpected market events. He is a chess player. Known to be good at poker and other card games as well, counts cards and such.

Saba’s trading shtick is relative valuation, exploiting mispricing along a single name’s capital structure. When he finds them, he buys the cheap and shorts the rich parts of this capital structure. There is usually a derivative overlay on it, with trades characterized by short, sharp lines that demand liquid entry and exit. He was one of the first to systematically use derivative overlays to implement this particular type of relative valuation strategy, known as “capital structure arbitrage”. I will refrain from technicalities because it bores most.

He is in a complicated position right now. The high yield rout started this fall, but the antecedents of it are grounded in June 2013, when Bernanke indicated that tapering of QE would begin. The incremental tightening of monetary policy has hammered the fixed income space as capital reallocates to the changing risk environment. Excess liquidity injected into the financial system means market liquidity diminishes.

There are deep, structural causes at work beyond the monetary policy impact on bond liquidity. According to RBS, (The Revolver July 23, 2014) the annual turnover of the US credit market in 2005 was 1.2x the total bond market. In 2014 the annual turnover has fallen to 0.7x total bond volume, implying a drop of 40%. You see trading volumes of about $20 billion a day for US corporate bonds, about 0.2% of the $10 trillion market. Even Treasury volumes have fallen off.

The structural component of this is due to costly regulation that discourages market making. Banks have to hold more capital against all assets, particularly low-rated bonds, lowering the margin on the business. This inventory cost will be passed on to hedge funds with little compensation for the liquidity risk exposure based on the bid-ask spreads of 5 year CDS, especially in high yield. A to BBB- rated corporate bonds are included in (high quality liquid assets) HQLA level 2 assets which benefits the high grade space. The liquidity coverage ratio for the rest leaves them subject to steep haircuts. Rather than making market more efficient and stable, new regulation and the forced risk-aversion has deterred banks from holding inventories of corporate bonds to trade.

The thinning of market-making activity in HY cash bonds impacts synthetics. An increasingly illiquid cash bond market marked by banks withdrawals from market making actually encourages the use of “synthetic” derivatives to be short or long in the absence of a functioning cash market. But the price is greater basis risk—the variance between a derivative and its underlying reference name. The lack of cash liquidity means that bond prices will remain relatively stable while derivatives become more volatile. The lack of liquidity means that when the long bond crowd gets jittery enough to attempt to sell some of the massive stockpiles of bonds that they have accumulated in recent years, both cash and synthetics can go haywire.

There is no clean line of attack here; there is instead a cramped position based on a shrinking market and thin, thin liquidity. Capital structure arbitrage often looks like liquidity-dependent rapid fire balancing of long and short positions and then exiting them in a timely fashion. It is more than this. It is about finding mispricing and exploiting it on some timeframe. However, the future of cap arb looks like strategies will need to adapt and become more positional and cramped than what these guys are accustomed to. It will make more sense to rely on reliable and strong negative and positive pairwise correlation relationships to dominate trading decisions, generalizing cap arb into shorting via credit default swaps limited to HG and HY indices, single names limited to cash markets, and treasuries remaining the time-honored hedge. It will be something with a more macro flavor.

Relative valuation trading won’t vanish, but trading of idiosyncratic risks on a single name won’t be around as much except in customized circumstances. Basis risk will need to be managed in an active art-not-science kind of way. In turn, shorting more liquid assets could substitute for shorting bonds as a kind of sausage making exercise.

Welcome to the revolution.

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