Trials and tribulations of trading

In the AFR today I write that while the life of an investor/trader can be stimulating, it is also stressful. The active investor is effectively betting that the collective wisdom of the crowd is mispricing an asset, which is a bold assessment that cannot be made lightly. If you disrespect the market, it will beat humility into you mercilessly. And your wins and losses are judged harshly: simply put, you either make good money, or you do not. Click on that link to read the column for free or AFR subs can click here. Brief excerpt enclosed:

It is very easy to aggressively express an unaccountable opinion online or in a newspaper column: it is quite another thing to back your views with billions of dollars on the presumption that the masses may be getting it slightly wrong over a very specific time interval, and then live or die by those decisions.

It definitely helps if you are part of a close-knit team. I have 23 executives working with me. Going into a zero-sum battle each day against such a ruthless and formidable adversary as the global financial market creates a unique--almost familial--bond through the searing intensity of the experience. While it is not a vocation for everyone, trying to prove acolytes of the efficient markets hypothesis wrong day-in, day-out is an intellectually rewarding commitment...

Since 1 January we have bought and sold more than $10.6 billion of bonds. We net purchased $937 million over the peak of the crisis and have net sold $1.2 billion since the end of March. While we are holding more cash than we have for some time, we are still long assets that appear to have a lot of mean-reversion left in them. In April we hypothesised that the credit spreads on the major banks’ five-year senior-ranking bonds could compress from the 175 basis points level they touched during the darkest days of March to new post-GFC tights around 50 basis points.

During the week these assets were bid at 46.5 basis points above the quarterly bank bill swap rate, setting a new post-GFC record. And it is entirely possible their spreads could contract further. The pre-GFC “tights” are, after all, around 10 basis points.

At the same time, the major banks’ Tier 2 subordinated bonds, which we have liked for a few months now, remain cheap and are still trading on spreads that are some 60 basis points wide of their post-GFC lows. They have nonetheless been moving in the right direction: Tier 2 spreads have shrunk about 180 basis points since mid-March.

The same can be said for the major banks’ hybrids. The five-year hybrid curve is sitting around 350 basis points, 110 basis points above their post-GFC tights. Like the Tier 2 space, hybrid spreads have compressed nicely from their “wides” of 841 basis points in March. Those brave enough to buy in March have earned non-annualised capital gains of 20 per cent to 30 per cent over a few months.

For all the talk about illiquidity in credit, it is a much misunderstood concept. If you held high-grade assets issued by unquestionably strong entities, there was always a bid in size in March. If, on the other hand, you held lower-grade assets issued by companies that perform badly in recessions (retailers, commercial property trusts, unregulated lenders, airlines etc), most folks would not touch them with a 40-foot cattle prod precisely because they are so cyclical...

One of the most interesting facets of liquidity is that it can be one-sided in markets dominated by a lot of group-think. In March, for example, the herd was rushing for the exits, desperately trying to sell. If you were the bid in this environment, you had almost infinite liquidity. While we net bought $937 million, on a gross basis (before netting sales), we actually bought over $1.5 billion in late February and March. In contrast, if you were the offer, it could be hard to get the bid you needed. Market impact costs were excruciating. And in some assets, like lower-grade corporate bonds, there simply was no bid.

The converse is true today. Since 31 March, we have gross sold $3.9 billion (ie, after netting purchases, that falls to $1.2 billion). During this time the bid has felt infinitely deep because the herd has been rushing to buy-back whatever they sold in February and March. There has also been a fear-of-missing-out dynamic as the mother-of-all mean-reversion trades played-out. 

Read the full column here.

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