Tuesday, August 23, 2016

Negative Yield Triangular Arbitrage

A question we often get is if the material we discuss is actually relevant to the real world. However, we can see the application of triangular arbitrage with the seemingly strange desire of investors to purchase the $9 trillion in below zero interest sovereign debt. A Japanese 3-month government bill is currently returning about negative .24 percent. The buyer can borrow at the yen 3-month LIBOR, which is about negative .02 percent and receive the dollar LIBOR at .82 percent. The buyer then executes a yen-dollar swap, which results in a dollar-hedged yield on the trade of 1.24 percent. With the 3-month U.S. Treasury yield about .25 percent, and increase in annualized return of about one percent is a huge increase for portfolio managers.

High Yield Bond Defaults Expected To Rise

Standard & Poor's Ratings Services expects default rates on high yield bonds to increase to 5.6 percent over the next 12 months, which implies that 99 issuers will default. The increase is due in large part to the decline in oil prices, although a delay in an interest rate increase by the Federal Reserve could offset the increase risk. However, in large part due to the low and negative interest rate environment, investors are pouring money into high yield investments resulting in a decline in the yield spread of high yield bonds dropping from 815 basis points in February to 560 basis points in July.