Tuesday, March 31, 2020

The Real Corporate Bond Puzzle

The conventional academic corporate bond puzzle has been that 'risky' bonds generate too high a return premium (see here).  The most conspicuous credit metric captures US BBB and AAA bond yields going back to 1919 (Moody's calls them Baa and Aaa). This generates enough data to make it the corporate spread measure, especially when looking at correlations with business cycles.  Yet BBB bonds are still 'investment grade' (BBB, A, AA, and AAA), and have only a  25 basis point expected loss rate (default x loss in event of default). 10-year cumulative default rate after the initial rating.  Since the spread between Baa and Aaa bonds has averaged about 1.0% since 1919, this generates an approximate 0.75% annualized excess return compared to the riskless Aaa yield. Given the modest amount of risk in BBB portfolios, this creates the puzzle that corporate bond spreads are 'too high.'

HY bonds have grades of B and BB (CCC bonds are considered distressed). Their yields have averaged 3.5% higher than AAA bonds since 1996, yet the implication on returns is less obvious because the default rates are much higher (3-5% annually over the cycle). As a defaulted bond has an average recovery rate of 50% of face, a single default can wipe out many years of a 3.5% premium. 

Prior to the 1980s all HY bonds were 'fallen angels,' originally investment grade but downgraded due to poor financial performance. Mike Milken popularized the market to facilitate corporate take-overs, and by the 1990s it became common for firms to issue bonds in the B or BB category. In the early 1990s there was a spirited debate as to the actual default rate, and total returns, on HY bonds. This was not merely because we did not have much data on default and recovery rates, but also because bonds issued as HY instead of falling to HY might be fundamentally different. Indeed, when I worked at Moody's in the late 1990's I came across an internal report, circa 1990, that guestimated the default rate for HY bonds would be around 15% annualized. HY bonds were not just risky, but there was a great deal of 'uncertainty' in the sense of Knight or Keynes (winning a lottery vs. the probability Ivanka Trump becomes president).

We now have 32 years of data on this asset class, and as usual, the risky assets have lower returns than their safe counterparts. There is a HY yield premium, but no return premium.

The primary data we have are the Bank of America (formerly Merrill Lynch) bond indices, which go back to December 1988. Here we see a seemingly intuitive increase in risk and return:

Annualized Returns to US Corp Bond Indices
Bank of America (formerly Merrill Lynch)
December 1988 to March 2020


These indices are misleading. Just as using end-of-day prices to generate a daily trading strategy is biased, monthly price data for these relatively illiquid assets inflate the feasible return. Managers in this space pay large bid-ask spreads, and if they are seen eager to exit a position--which is usually chunky--this generates price impact, moving the price. Add to this the operational expense incurred in warehousing such assets, and we can understand why actual HY ETFs have lagged the Merrill HY index by about 1.4%, annualized

High Yield ETF Return Differential to BoA High Yield Index
2008 - 2020
2007 - 2020
JNK v. BoA
HYG vs. BoA
JNK and HYG are US tickers, BoA is their High Yield Total Return Index

With this adjustment, the HY return premium in the BoA HY index disappears relative to Investment Grade bonds. In my 2008 book Finding Alpha I documented that over the 1997-2008 period, closed-end bond funds showed a 2.7% return premium to IG over HY bonds.

Via Twitter, Michael Krause informed me about a vast duration difference in the ETFs I was examining, and so I edited an earlier draft for the sake of accuracy.

More recently, we can look at the difference in the HY and IG bond ETFs since then. HYG and JNK have an average maturity of 5.6 years. Investment-grade ETFs LQD and IGSB have maturities of 13 and 3, respectively. Adjusting for this, this implies a 200 basis point (ie, 2.0%) annualized premium for HY ETFs.

There is a 50 basis point management fee for the HY ETFs, about 10 bps for the IG ETFs. Given the much greater amount of research needed to buy HY ETFs, it reflects a real cost, not something that should be ignored as exogenous, unnecessary.

This generates, actually, a nice risk-return plot: linear in 'residual volatility', the volatility unexplained by interest rate changes.

Tuesday, March 10, 2020

OracleSwap: An Open-Source Derivative Contract Suite

A couple of years ago, I thought it would be good to create a crypto fund. I soon discovered that as a registered US firm my options were severely limited. I could go long or short a handful of crypto names over-the-counter, but they had excessive funding rates for going long and short (eg, >12%), and required 100% margin; I could short bitcoin at the CBOE, but I had to put up five times the notional as collateral. No reasonable estimate of alpha can overcome such costs. To use popular exchanges like Deribit or BitMEX would require lying about my domicile which would violate US regulations related to investment advisors, and also diminishes my legal rights if such an exchange decided to simply not give me my money back.

So I thought, why not create my own derivatives contract? Ethereum gives users the ability to create simple contracts, and nothing is more straightforward than a futures contract. I figured I could create a contract where the money at risk would be small relative to the notional, and its oracle would be honest because of the present value of this repeated game. The basic idea was simple enough, but the details are important and difficult, which turned this into a 2-year trip (I have sincere empathy for Ethereum's development pace).

Many initial crypto enthusiasts were motivated by the belief that our traditional financial system was corrupted by bailouts and greed. Ironically, the standard floundering blockchain dapp is constrained by their earlier short-sighted greed. Enterprising capitalists discovered that if you sell tokens, you can propose a vague blockchain business model and people will think it will be just like bitcoin, only it would offer insurance, porn, or dentistryThis required corporate structures because even in 2017 no one was gullible enough to invest in a token that funded an individual. Supposedly, the token is for use and decentralized governance, the latter implying all of the desirable bitcoin properties: transparency, immutability, pseudonymity, confiscation-proof, and permissionless access. Yet consensus algorithms are much easier to apply to blockchains than cases where essential information exists off the blockchain; non-blockchain consensus mechanisms do not generate all of those desirable bitcoin properties because they are much easier to game. 

Decentralization is a good thing, but like democracy, not at every level. A nation of purely independent contractors would never have developed the technology we have today, as things like computer chips and airplanes require hierarchal organization, and hierarchies need centralization. To relegate a market to atomistic, anonymous participants implies either an intolerable base level of fraud or costly adjudication mechanisms that jeopardize security and delay payments. A free market is built on a decentralized economy, which is based on free entry by firms and free choice by consumers. The degree of centralization within those firms is particular to a market, some of which should be large (e.g., banks).

The Coase Theorem highlights that the optimal amount of vertical integration depended on transaction costs related to information, bargaining, and enforcement. This is why firm size varies depending on the product. Naïve types think that we should just have small businesses because then we would have no oppression from businesses wielding market power. Given our current level of technology, that implies mass starvation. The naïve extension is that we should have large firms, but they should be zealously regulated by selfless technocrats. This ignores the universal nature of regulators, who protect existing firms under the pretext of protecting the consumer. This latter point is especially relevant as most protocols have some ability to permission access, and regulators will hold them accountable. Large institutions do not like competition, and governments do not like complete independence among their subjects, resulting in either KYC or curiosities like trading CryptoKitties.

The alternative I present is based on the idea that decentralization is basically competition, and that dapps can simply inherit the essential bitcoin properties by being on the blockchain without tokens and avoid convoluted consensus algorithms. That makes it cheaper and easier to design a viable product. A pseudonymous ethereum account allows oracles to develop a reputation because its actions are transparent and immutable; outsiders cannot censor it. Lower costs, crypto-security, and pemissionless access, provides a valuable way for people to lever, short, and hedge various assets: the initial contract has derivatives on ETHUSD, BTCUSD, and the S&P500.

The result is OracleSwap, an ethereum derivatives contract suite. I have a working version on the web, at oracleswap.co. While it is live on the Ethereum Main Network, it is restricted to margins of 1 or 2 szabo, which even with leverage is well under $0.01 in notional value. It is meant to provide an example. I would be an oracle and liquidity provider myself, but as a middle-aged American, that is not practical. I have fingerprints all over this thing and my friends tend to have good jobs in the highly regulated financial sector, and we would have a lot to lose by violating US regulations (e.g., CFTC SEF regulations within Dodd-Frank, FinCEN, BSA). Yet there are many who can and do invest in exchanges prohibited to US investors, and such investors need better choices.

Many competent programmers have the ability and resources to modify and administer such a contract (you can rent server space for $10/month). The oracle is honest because the present value of oracle revenue is an order of magnitude greater than a cheat. Further, the oracle has economies of scale, so those who are disciplined can create a working product, and by the time they graduate, they will have generated a couple-year track record supplying timely and accurate data. 

Several innovations make this work, all focused on radical simplicity. This lowers costs and reduces direct and indirect costs. The most important innovations are the following:  

·         Forward-starting prices

Trades are transacted at the next-business-day closing price. As this contract targets long-term investors, the standard errors generated by differences in various 4 PM ET prices are minimal and unbiased (the median of several sources over different intervals within a 5-minute window for crypto, the SPX uses the close price). As an institutional investor, I always used next-day VWAP prices. Limit order books generate many complications, and provide nothing of interest to long term investors; day trading blockchain assets is predicated on delusion. 

·         LP netting

The key to market-making capital efficiency is allowing the liquidity provider to net trades. Without a token, this had to be done through netting exposures at the weekly settlement. The LP's are basically mini-exchanges, in that long and short positions are netted. Weekly settlement can handle 200 positions in a single function call, but this can be broken up into 200-unit chunks, allowing an almost unlimited set of positions for any LP. They balance long and short demand by adjusting their long and short funding rates. The Law of Large Numbers implies larger LPs will have more balanced books, allowing them to generate a higher gross-to-net asset ratio, which implies higher returns for a given level of risk and capital; LPs are incented by economies of scale, not delusional token appreciation. 

·         The oracle

This contract is designed for those who want to stay off the grid, and so its pseudonymous oracle can maintain its anonymity and avoid censorship. Its main costs are fixed, as once the contract, front-end, and automated scripts for updating prices are created, maintenance is trivial. The oracle is kept honest via the repeated game it is playing, and the ability and incentive for users to burn their PNL rather than submit to a fraudulent PNL at settlement. A centralized oracle is much easier to incentivize because it is all-in on the brand value of its oracle contract, as a cheat should eliminate future users.

the only way to cheat involves colluding with an oracle that posts fraudulent prices, so the contract focuses on minimizing a cheat payoff while concentrating the cheat cost on the oracle. An oracle's reputation is black or white, as its history of reported prices is easy to monitor, and no rational person would ever use an oracle that cheated once. All of an oracle's brand value is in the contract due to its pseudonymous nature, so there is less incentive to sell-out to seize or protect some traditional brand value (e.g., Steem). While explaining the incentive structure requires more space than I have here, the crucial issues are that players have the ability and the will to decimate a cheat. 

Not only are the ethereum contracts open source, but the web3.js front end is as well. By downloading the web front-end users can eliminate the risk that someone is watching their interactions with the identical front-end hosted at oracleswap.co. Yet, it is mainly a template for developers. I hired people to create the basic structures as I am not a hard-core programmer, but I have modified them endlessly and in the process had to learn a lot about Drizzle/React, JavaScript, Python, and Solidity.

Python is for the APIs that pull prices from data providers and post them to the contract. This has to be automated with error-checking processes and redundancies. You can send questions related to this contract to ericf@efalken.com. I can't promise I'll respond, but I'll try.


This site is not encrypted--http as opposed to https--but as this contract is denominated in szabo, and the website and contract do not ask for no user information such as emails, etc, users can interact via MetaMask or MyCrypto.com without worry. Users can also download the front-end from GitHub and run a local version with all the same functionality (it's open source). It is fully functional.

Technical Document

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