In the first three installments [Click here for => (Part 1)(Part 2) & (Part 3)] of this series, I reviewed my history in the credit markets and introduced the “Fulcrum Index”, an index that calculates the cumulative value of CDS Insurance on a basket of G-20 Sovereign nations multiplied by their respective funded and unfunded obligations. This dynamic calculation forms the basis of a current valuation for bitcoin — the anti-Fiat. This methodology determined that a fair value for bitcoin is between US$110k/coin and US$160k/coin, TODAY.
At a current trading level of approximately US$40k/coin, the Fulcrum Index would indicate that bitcoin is cheap to fair value. As such, given that every fixed income portfolio is exposed to sovereign default risk, it would make sense for every fixed-income investor to own bitcoin as portfolio insurance. As sovereign CDS spreads widen – reflecting increased default risk – the intrinsic value of bitcoin will increase and this will be the dynamic that allows the Fulcrum index to continually revalue bitcoin.
Moreover, on an expected value basis, bitcoin is also cheap. And, with each day that the bitcoin network survives and gets stronger, the left-hand side (tail) of the probability distribution continues to decrease while the right-hand side asymmetry is maintained.
Accordingly, I state for a final time: Bitcoin is the best asymmetric trade I have seen in my 32yrs of trading, and I believe EVERY (fixed income) investor needs exposure to bitcoin. Having zero exposure to bitcoin is riskier than having a 5% portfolio weight.
4.1 – Feedback from Prior Installments
I have received some valuable feedback from readers. I thank you for the kind words as well as the questions.
I paraphrase the main question as follows; “If countries can just print, they can never default, so why would CDS spreads widen?” I provide two examples below.
Firstly, the same thing was said about Lehman Brothers having an implied backstop by the US government and that it would never fail. The GFC showed us otherwise, and the CDS spread of 9bps (US$9k per annum to insure US$10mm of debt) that LB protection was offered at in 2006 turned out to be a very valuable insurance policy. The CDS of other financial players also widened in lockstep as CONTAGION spread through the markets, and while other players survived (no event of default occurred), the CDS protection was still a valuable policy that could have been sold to crystallize the value of the protection. The same dynamic will apply to the correlations of sovereign CDS spreads.
The bankruptcy of LB was a true awakening for all market players. An institution that was deemed by some as “too-big-to-fail” was not rescued by the Government. The cascading credit crisis became even more real as people who had assets custodied at LB as well as players who had purchased CDS protection from LB were suddenly exposed to risks as a major counterparty failed. CONTAGION.
Secondly, sovereign credits do default even though they can print money. Remember the LDC crisis in 1988. Or Venezuela in 2020 where Fiat is shovelled to the curb as garbage. It becomes a crisis of confidence and existing holders of government debt do not ROLL their obligations and instead demand cash. They can “print” the cash, but if it is shoveled to the curb, we would all agree that it is a de facto default.
4.2 – An example of CDS Contagion
In previous installments I laid out the leverage in the financial system, and why the unwinding of this leverage is what ultimately leads to crises exploding. The following example is particularly timely since we have just experienced a similar event in the Gamestop (GME) affair.
GME caused leverage to unwind which cascaded through the equity markets and was reflected in increased equity vol (and associated pressure on credit spreads). It happened as follows. Up to 15 major hedge funds were all rumored to be in trouble as their first-month results were horrible. They were down between 10% and 40% to start the 2021 year. Cumulatively, they controlled about US$100B in assets, however, they also employ leverage, sometimes as high as ten times levered.
I quote from the Bear Traps Report, Jan 23, 2021, “Our 21 Lehman Systemic Indicators are screaming higher. The inmates are running the asylum…when the margin clerk comes walking by your desk it is a VERY unpleasant experience. You don’t just sell your losers, you MUST sell your winners. Nearly “everything must go” to raise precious cash. Here lies the problems with central bankers. Academics are often clueless about systemic risk, even when it is right under their noses. The history books are filled with these lessons.”
Consider a hedgie that uses ten times leverage and sells protection on a basket of sovereign credits “to collect that free premium” and generate a high leverage aided ROI. The hedgie has been a consistent seller, even as spreads have widened. The market runs to the hedgie for more protection, they sell more. Then the margin clerk walks buy and suddenly the only seller of protection needs to reverse course to raise cash. They are now also a buyer, in a market where there are only buyers, spreads explode.
In the following exhibit, the title says it all: “Despite active de-grossing, fund leverage remains elevated”. This is what happens in an era of low rates. Costs of borrow are low, leverage is used to chase yield and make yield producing assets attractive on a leverage adjusted basis. “High yield” bonds have NEVER been lower yield (moved under 4% for the first time in history). See Appendix I for discussion on this absurdity for anyone who owns a HY Mutual Fund.
What does all this leverage do? It increases the risk of the inevitable unwind being extremely painful while ensuring that the unwind fuels the CONTAGION. A default does not have to occur in order for a CDS contract to make money. The widening of spreads will cause the owner of the contract to incur a mark-to-market gain, and conversely, the seller of the contract to incur a mark-to-market loss. Spreads will widen to reflect an increase in the potential for default. And, there will be a correlation between widening sovereign spreads as systemic risks absorb the leverage unwind.
Roger Lowenstein’s bestseller “When Genius Failed, The Rise and Fall of Long-term Capital Management”, is a must-read for all risk managers and market historians. LTCM was a huge hedge fund that employed two Nobel prize-winning economists and a team of elite traders. Their pocket strategy was essentially to sell volatility and enhance returns using leverage. When Wall Street banks needed to purchase options (buy volatility) they went to LTCM. LTCM sold, when vol widened they sold more, as the street needed more protection, they sold more…
At one point they remark, “Markets are broken. Vol is at 99% confidence intervals, according to our models”. Problem was, their models were based on SEVEN years of historical data. Wow. Nobel prize winners eh? Seven years of data!!! What a farce. Yet the “Bank of volatility”, almost brought down the street. LTCM was bailed out in 1997, and the party soon continued. Socializing loses has enduring consequences as the can was once again kicked down the road.
Risk happens fast.
4.3 – Concluding Remarks
Bitcoin is the purest form of monetary energy and is portfolio insurance for all fixed-income investors. In my opinion, it is cheap on most rational expected value outcomes. You can never be 100% certain. The only thing that is a certainty is Fiat debasing in a debt spiral. Hedge the global Fiat Ponzi.
In a debt/GDP spiral, the Fiat currency is the error term. All Fiats are melting ice cubes. The rate of decay is relative, but all Fiats melt. It is only math.
I believe there is a real chance that bitcoin becomes the reserve asset of the world. The tipping point for that event is when bitcoin is adopted as a global unit of account for the trade of energy products. When oil, natural gas and electricity are priced in bitcoin, bitcoin will supplant the USD as world reserve currency/asset. The following picture is from the New York Tribune in December 1921, and Henry Ford calling for “An energy currency that would stop wars”.
I believe it is logical for countries who are selling their valuable energy resources in return for worthless Fiat money to move from the Fiat-based US dollar as a reserve asset, to bitcoin. Digital energy stored on the world’s largest and most secure computer network, in return for energy that has been stored as fossil fuels, or hydropower, or solar power. It is a natural evolution built upon the first law of thermodynamics – Conservation of Energy.
“Bitcoin mining will be the most profitable use of energy in human history, that does not need to be located close to human settlement. Once the mining is built, the human settlement will follow” – Ross Stevens.
Cheap energy has always resulted in human flourishing via increased productivity. Many bitcoin critics argue that bitcoin wastes energy. I contend that bitcoin consumes energy waste. From flare gas projects to wasted energy resources that are too far from the human settlement (you can only efficiently transport electricity about 500 miles), bitcoin mining can actually be used to stabilize the electricity grid as a system that is built for overcapacity (peak loads) can be more efficiently employed with miners that bridge the power gap.
Bitcoin mining increases the revenue and risk/return prospects for new energy projects. The Canadian energy patch would benefit greatly from these new revenue sources. Capital can be allocated more effectively. Entire communities and provinces can benefit. Trickle-down effects such as ASIC chip manufacturers returning to North American soil due to the increased demand for miners can also be put into the playbook.
“Money is technology for making our work/time/energy expended today, available for consumption tomorrow” – hat-tip Ross Stevens (I added my own twist).
By that definition, bitcoin is the purest form of money and Store of Value (SoV) that mankind has invented. Choose your SoV wisely. Bitcoin equals math plus code. The code is open-source. “Don’t mess with open-source software, you will lose every time” — Jack Mallers.
RISK HAPPENS FAST. BITCOIN IS THE HEDGE
Thanks for reading and thanks to Tom and Nick and the Rock Star team for teaching me the ropes.
Reach me on Twitter at @fossgregfoss – concerned but Optimistic Canadian
Interested in reading the previous parts leading to this article? You can jump to them directly using the links below
If you own a HY Mutual Fund at the current Sub 4% YTM, be aware of the downside risk
The following is a graph of the BOAML HY Index since 1998. This spans my entire trading career. In fact, I was trading credit for ten years prior to the start of the index. Take a minute to look at the graph and align the spikes in yields to various events in the global financial markets. (The grey shaded areas denote economic recessions.) Note the typical economic cycle and how it is reflected in the graph of yields.
Three events jump out at me. Firstly, the GFC where yields on the index jumped to over 20%. This was in spring of 2009, where I remarked earlier that I was going to the trading desk each day wondering if the financial world was ever going to recover. Note the recovery (reduction in yields) from 2009 to 2015 where QE and Fed accommodation drove a compression (of spreads and) yields. Secondly, the hiccup in 2016, where there was a taper tantrum, and concerns over the solvency of Middle-European countries. Thirdly, the COVID spike in 2020 and subsequent recovery to where yields are now at 4%YTM.
The current YTM in HY guarantees that owners of HY Mutual Funds will have a negative annualized real return over a five-year holding period. As usual, It is only MATH.
Defaults in credit are an EXPECTED loss. If you can perfectly predict expected losses, then you can perfectly price credit to ensure a proper return on risk. The problem is you cannot perfectly predict expected losses and thus UNEXPECTED losses need to be priced into the return assumption.
Default rates in HY are expected to exceed 4% going forward, as the lingering effects of the latest recession work its way through the credit cycle. Recovery rates (in the event of default) are typically in the area of 40%, thus a 4% default rate with a 40% recovery rate implies a loss of 2.4%. In the past, default rates have soared past 10%, implying a loss of 6%, but let’s use a default rate of 4% for now. The MATH is still ugly.
The 4% YTM on HY minus expected losses of 2.4% leaves an expected return of 1.6%. Subtract a management expense ratio (MER) of 40bps for your typical HY mutual fund and you are left with an expected return of 1.2% in nominal terms. Subtract inflation and you are left with a negative expected REAL return in HY bonds.
This is before we account for UNEXPECTED losses, and the return required to compensate investors for this reality. Accordingly, the expected return on HY is the worst that I have ever seen in my career. Anybody who owns a HY mutual fund needs to take note: You are not earning an appropriate return on your risk. Remember, when the perception of risk is low, the actual risk is high. Conversely, when the perception of risk is high (reflected in high yields), the actual risk is reduced.
In summary, the HY market is heading for a major reckoning. The graph shows that the credit cycle is predictable and natural. This will lead to CONTAGION in other markets including widening spreads in high-grade credit and sovereign CDS spreads. Also, volatility in equity markets will invariably be impacted. Remember, credit is a dog. The equity markets are the tail that gets whipsawed like a ragdoll.
The process becomes circular. Increased spreads lead to increased vol. When you are long credit, you are short vol, and to reverse that exposure, you need to buy vol (protection). The spikes always return as CONTAGION and correlation kick in.
Proceed accordingly. Risk happens fast.