The Buffett/Seides Bet

An interesting article here talks about the fact that ~10 years ago Warren Buffett bet Seides $1 million that the S&P500 would beat a bunch of hedge funds. The times about up, and Warren won.

They put the collateral for the bet in a zero coupon US gov’t treasury bond. Over the same 10 years that bond went up:

300%

Annually, the S&P returned ~7%, hedge funds ~2% and the bonds 11%.

10 year interest rates at the time were ~4%. Today they are 2%. Because it was a zero coupon bond that 4% was locked in. That obviously made the bond jump in value. Now with the Fed hiking I’d imagine that bond wouldn’t perform the same way…

From RBS:

What are zero coupon Treasuries?

In general, a zero coupon bond is any bond which doesn’t pay periodic interest. Earnings (interest) accrete over the life of the bond as the difference between a deeply discounted purchase price and the bond’s maturity value. Zero coupon bonds are priced to earn yields prevailing in the current market. A zero coupon Treasury bond is simply a zero coupon bond on which payment is derived from an underlying Treasury security. This bond is created by taking a Treasury note or bond and first separating its coupon payments from the final principal payment in a process called coupon stripping. After this “stripping” process, securities are issued to match the maturity of each of the coupon payments with a final maturity payment. To illustrate this process, suppose a $100 million face value 10-year Treasury note paying a coupon rate of 10% is purchased to create zero coupon Treasury securities. The cash flow from this bond would be 20 semi-annual payments of $5 million each, plus one final payment of $100 million. Receipts are then issued to coincide with the maturity date and value for each of the coupon and final maturity payments. This process creates 20 coupon strip receipts with a maturity value of $5 million each, and one maturity receipt with a principal value of $100 million. These newly created strips are sold as separate securities. The price of the receipts would be discounted to reflect current market rates. This general process is the same for all of the zero coupon Treasury products.

Why buy zero Treasuries?

Purchasing zero coupon Treasury securities provides investors with a number of advantages:

• Guaranteed return/reinvestment risk eliminated — One of the main benefits of purchasing zero coupon Treasuries is that the investor earns a guaranteed return while eliminating reinvestment risk. With conventional Treasury bonds, coupon payments received over the life of the bond must be reinvested, possibly at lower rates. Zero coupon bonds eliminate this risk since there are no periodic payments. The investor’s return is generated over the life of the bond as the interest accumulates, a process called accretion.

more here.

Contagion

This video is from Martin Armstrongs site. It showed a video which portrays a concept that I think was in Nassim Talebs book Antifragile. Like the butterfly effect, one small domino creates a chain of events that lead to big happenings. Below are some issues to keep an eye on.

Three things I have seen might start the chain of events:

The “50 Cent” VIX Buyer Doesn’t Care

There is a fair amount of coverage on “50 Cent” the VIX buyer who is offloading cash into VIX calls (generally priced at 50 cents) to the tune of an estimated $80 million dollars.

You don’t get to be in a place where you can lose that type of premium unless you are smart. I don’t think this guy is just ad-hoc betting on a market collapse. I suspect he’s shorting the heck out of volatility ETP’s (UVXY, VXX, etc) or hedging long positions in XIV, SVXY etc.

One of the things that always pops up are headlines reading “RECORD INFLOWS INTO VOLATILITY ETPS – INVESTORS BETTING ON COLLAPSE”. I have not done the math (yet) but, for a thought exercise:

Could the guy plowing unbelievable amounts of money into VIX options be the on the other side of all the retailers plowing unbelievable amounts of money into volatility ETP’s? I think the liquidity is there to offset $80mm in VIX calls…

VOLATILITY ETP INFLOWS
long volatility ETP’s inflows

Paris Shooting

Police offers were just shot in Paris, 3 days before the election. Volatility sold off all day and the US market rallied as the latest polls gave Macron a better lead.

Paris Shooting
Paris Shooting

The French have no said who is responsible – but *if* its a terrorist (as in Islamic) attack will that substantially swing things? You’d have to think that this tilts things slight more toward Le Pen…

The close today might have been a great time to add some hedges as the markets could react sharply overnight on this.

Pensions “Transferring Risk”

Several items in this article from CIO caught my eye. Article pasted in below, but essentially corporate pensions had a better return last year than expected, and were also aided by a drop in life expectancy. Pensions obviously have huge liability issues with many of them underfunded. The idea that shortening life spans might help ease the pain is one [very sad] variable that hadn’t occurred to me.

Life Expectancy

What was also interesting was that pensions were able to “transfer pension risk to insurance companies”. This concept was new to me. Apparently the pensions can purchase annuities from insurance companies which cover some of their risk. The pensions can also offer lump sums to the pensioner. Both of these strategies allow the pensions to have more defined benefits going forward.

Here is a primer on one way the pensions transfer risk:

Annuity Transfers

Features

  • Employers make a deal with an annuity provider, usually an insurance company, to transfer a certain amount of plan assets, plus pay additional fees, in return for monthly payments to plan beneficiaries when they retire.
  • Participant consent is not required.
  • Retirees’ monthly payments are the same as they would be under the plan, but they are made by the insurer and are not guaranteed by the federal Pension Benefit Guaranty Corporation.
  • Employers must choose their providers carefully with documented due diligence under the guidance of an independent plan fiduciary.

Full article below:

More Corporate Pension Plans Transferring Risk, Milliman reports

Despite fluctuations, the largest pension plans ended 2016 with their funded ratios little changed.

The 100 largest US corporate pension plans saw their funded status drop to 81.2% for 2016, from 81.9% a year earlier, according to actuarial firm Milliman. The $21.7 billion drop in funding resulted from a rise in projected benefit obligations, partially balanced by a rise in the market value of plan assets.

The 100 plans also witnessed quite a bit of volatility in 2016, Seattle-based Milliman reported. “Investment performance exceeded expectations, with the 100 largest US pensions experiencing returns of 8.4%—compare that to 0.8% the year prior,” said Zorast Wadia, an actuary and co-author of the pension funding study, “but the volatile interest rate environment saw the discount rate plummet by 30 basis points. In 2016, these dynamics resulted in a funded ratio that oscillated back and forth for most of the year before the post-election bump. The end result was a funded ratio of 81.2%—not that far off from where we’ve been at the end of 2015 and 2014.”

Three factors buoyed the 100 largest corporate plans. One was an investment return of 8.4% for 2016, outperforming expectations. Another was employer contributions, which rose 38% from 2015 levels. A third was a decline in estimated life expectancies for the second year in a row, which helped cut projected benefit obligations at several of these companies.

Some companies are planning to adopt an accounting change to cut their pension expenses for fiscal year 2017. This entails moving to spot interest rates that are based on the yield curves of high-quality corporate bonds. For 2017, 46 companies in the Milliman study said they intended to adopt this practice, compared to 37 companies for 2016.

Plan sponsors also boosted their engagement in strategies to transfer pension risk to insurance companies. Pension risk transfers, together with pension risk settlement payments to former plan participants who are not yet retired, rose to $13.6 billion in 2016, from $11.6 billion in 2015 and included such companies as Westrock, United Technologies, PepsiCo, Hewlett-Packard, International Paper, and Verizon. By doing so, plan sponsors also cut down on their required premium payments to the Pension Benefit Guaranty Corporation.