So You Want To Replicate Julian Robertson's Constant Maturity Swap Trade. Just Call Morgan Stanley

Tyler Durden's picture

It is no secret that Julian Robertson is not a huge fan of long-dated bonds. In his recent CNBC interview he had some downright nasty words about the back-end of the UST curve, especially if the "downside contingency" case of foreign purchases ceasing, were to pass. However, while many have known about his propensity for the bond steepener trade, his latest trade position is the so called Constant Maturity Swap trade. Moving away from an outright steepener makes sense as it can now only profit from a tail end widening, since the front end of the curve is at zero. Unless Bernanke follows Sweden into negative rates territory, the steepener upside potential has just been mechanically limited by 50%. As for his current preferred iteration of expressing Treasury bearishness, CMS, here is some recent commentary from JR on the topic:

"The insurance policy I would buy is called a CMS Rate Cap, which is the equivalent of buying puts on long-term
Treasuries. If inflation happens the way it could, long-term Treasuries
are just going to explode. Less than 30 years ago, long-term interest
rates got to 20%. I can envision that seeming like a very low interest
rate compared to what might occur in the future."

No surprise then, that Morgan Stanley's Govvy desk has started pimping this trade (including some hedged and Knock Out variants) to anyone who wants to imitate that original Tiger. In a recent version of their Interest Rate Strategist, the key proffered trade is precisely Shorting back-end rates, with the following summary recommendations:

  • Buy a 5 year Cap on 30 year CMS struck ATM (5.38%) for 105 bps
  • Buy a 5 year Cap on 30 year CMS struck ATM. Sell a 5 year Cap on 30 year CMS struck at 8.38%, for a net cost of 65 bps.
  • Buy a 5 year Cap on 30 year CMS struck at 5.38% that knocks out in 1 year if 30 year CMS is above 5.38% for 62 bps.

Here is MS' entire modest proposal:

In the past month, longer-dated volatility has declined and longer-dated rates have rallied (Exhibit 1). Getting short back-end rates – with defined downside – is becoming increasingly attractive. We maintain our long-held belief that, in the long run, the curve will steepen significantly, and we continue to believe that long-dated rate caps will benefit from the higher rates and higher volatility that will come from increased Treasury issuance and an end to the public stimulus programs.

Specifically, we propose a selection of the following trades:

  • Buy a 5y cap on 30y CMS struck ATM (5.38%) for 105bp
  • Buy a 5y cap on 30y CMS struck at 5.38%, Sell a 5y cap on 30y CMS struck at 8.38%, for a net cost of 65bp
  • Buy a 5y cap on 30y CMS struck at 5.38% that knocks out in 1y if 30y CMS is above 5.38%, for 62bp

Inflation and long-end supply remain substantial concerns, particularly for longer maturities. Our economists expect 10y UST gross issuance to more than double from 2008 to 2009, and for 30y UST gross issuance to more than triple. After 2009, we also project 10y UST issuance to increase by $40 billion per year, and long bond gross issuance by approximately $50 billion per year (Exhibit 2). This is while the Fed is projected to keep short-term rates on hold in order to stimulate the economy and maintain a steep curve.


We aim to target 30y rates. This is because we project 30y UST gross issuance to keep increasing at a faster pace than 10y gross issuance (Exhibit 2). Moreover, we expect the curve to steepen in periods of high inflation.


We also target longer expiries (3-5y). Two reasons behind this: first, we have been in a secular downward trend in longer-term rates since the mid 1980s (Exhibit 3). This is a trade for us to break out of that range – we expect such a shift to occur over a longer period of time as opposed to in the next year. Second, flows out of lower yielding money market funds into the belly of the curve are expected to keep longer rates bid, at least for the next couple of months, in our view. This is something that we can exploit by entering into a knock-out cap.


Investors looking to decrease the upfront cost of the option can accomplish this in one of two ways: either by limiting their upside, or by playing the timing of the sell-off in longer-dated rates.
Limiting the upside would involve selling an OTM cap against the ATM cap that the investor is long. For instance, if the investor sells a 300bp OTM cap against buying long an ATM cap, this cheapens the upfront cost of the option to 65bp, or by 38%. Note that OTM skew on longer tails has richened substantially over the past three months. Exhibit 4 graphs the spread between 100bp OTM 5y30y payors and 100bp OTM receivers, normalized by the level of at-the-money vol – the higher this spread, the more expensive payor skew is relative to receiver skew. Over the past three months, OTM payor skew has become increasingly expensive. This is why we prefer monetizing and selling it as opposed to moving the strike of the CMS cap that we’re long further out of the money.
Playing the timing of the sell-off in longer-dated rates would cheapen the upfront cost of the cap by selling a shorter-expiry option against the longer-expiry cap. Flows out of money market funds into the belly of the curve are likely to keep the long end somewhat bid in the near term, in our view. Investors can monetize this by entering into a 5y cap on 30y CMS rates that knocks out in 1y if 30y CMS is above a strike of their choosing. For instance, a 5y cap on 30y CMS struck ATM (5.38%) that knocks out in 1y if 30y CMS is above 5.38% has an upfront cost of 62bp; if investors move the strike of the knock-out to 6%, the cost increases to 79bp. Note that a 2y knockout cheapens the cap even more than the 1y knockout. The principal risks to the outright CMS Cap are either that rates continue to rally, or that vol falls. Note that both of these risks are mitigated with a 1x1 cap spread, or with a knock-out cap. In each of the three trades, however, the maximum downside for investors is equal to the initial premium invested.

If last week's pounding of the 30 year is any indication, Robertson may just be on the right trade yet again. The demonstratory selling of 30 years both into and after the Auction was obviously agenda driven, and it is doubtful it bypassed Bernanke's, and the PD's attention. Yet as China is increasingly boxed and realizes fully well it needs to buy some Treasuries (lest it sends the world a signal that it is willing to write off its $2.5 trillion in dollar reserves), it is conceivable that going forward it will merely focus in the 1-3/5 Year Tenor range, as it leaves anything 10 years and out to other, Fed financed chums. Some desks have in fact argued that what the ABX trade was for subprime, and CMBX was for CRE, the CMS trade will end up being for Treasuries. Although be careful: while your opponents in the first two were subprime borrowers and Cohen & Steers respectively (hardly admirable opponents), in the last trade you are taking on the Federal Reserve and the full faith and credit of the US head on. For if the Fed losses control of the 10-30 year span, it might as well go home, since that means 30 Year mortgages will skyrocket,maybe all the way into double digit territory, thus destroying all hopes of inflating the GSE bubble.
Yet as Soros showed in the 90's, Central Banks can lose. All that needs to happen to topple Ben, is for the bond vigilantes to come out in force and support Robertson's fatalistic view on USTs. Not even the worlds most overheating printing press can take on the combined power of all the bond vigilantes in the world. Although, it is arguable if one can take on the Fed via passive strategies such as CMS. Someone with real guts would have to be the first to go all out and short the back-end. If substantiated by a sufficient number of synthetic bearish positions, at that point it will be merely a matter of time before Bernanke is finally forced to fold his endless deck of Aces.
For some additional color on CMS, we recommend this paper from Goldman Sachs.

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Michael's picture

OT; Political

Cap N Trade not called Cap N Trade anymore :
John Kerry now calls it :
“The Pollution Reduction and Investment Incentive Mechanism”.”


Here’s another good one I renamed.

US Surveillance and Rights Reduction Act aka Patriot Act

We will change the name of any act by congress to more accurately reflect the contents of any act up for a vote or passed by congress!

You don't have to refer to a misnamed act by congresses given name. You can rename any act to it's truthful descriptive name.

We should have a poll on what the proper name of any act should be, up for a vote or passed by congress.


Screw saving the planet. How about we save our own country first.

putbuyer's picture

I'm with you brother. I think David Kahane sums it up pretty well.

In this brave new world that’s a’borning, everything will change. Your money will be worth nothing. Your houses will be worth nothing. You won’t be able to afford even an energy-saving light bulb, much less turn it on. The jobs you’ll get — if you can get jobs — will be the modern equivalent of the Irish and African-American tarriers who dug the IRT subway lines in Manhattan around the turn of the last century for ten cents an hour, if they didn’t die first. Luckily for us, you’re too busy with Michael Jackson grief, Ed McMahon grief, Farrah Fawcett grief, Gale Storm grief, David Carradine grief, and Billy Mays grief to pay the slightest bit of attention to what is really going on.

AN0NYM0US's picture

“The Pollution Reduction and Investment Incentive Mechanism”

managed by the “Pollution Reduction and Investment Committee” (PRICK)

Anonymous's picture

October 9, 2009
Just over a year after economic calamity brought promises of reform from Washington, has Wall Street really changed? Former International Monetary Fund chief economist Simon Johnson and US Rep. Marcy Kaptur (D-OH) report on the state of the economy.

TumblingDice's picture

Hmmm...I may have to talk to MS pretty soon about this lucrative opp.

AN0NYM0US's picture

and this was JR's favorite trade back in the dark days of October 2008
Curve Steepeners (starting @ minute 2:20)

and here is an article from marketfolly earlier this year
Julian Robertson's Steepener Swap Play (Shorting US Treasuries)

Michael's picture

Overy at most people are rooting for Iran.

Cheeky Bastard's picture

so am I ( but those people at Infowars are generally fucked up IMHO )

deadhead's picture

that 9-24 high on spx closed a lot of those bears out.

they are just waiting.  first whiff of fear and first selling actions by the long funds will see the pounce. volumes, volumes, volumes.

putbuyer's picture

From Trading Places

The people with pork belly contracts are thinking,

"Hey, we're losing all our money and Christmas is coming.

"I won't be able to buy my son the GI Joe with the Kung Fu grip.

"And my wife won't make love to me cos I ain't got no money."

They're panicking, screaming, "Sell, sell."

They don't want to lose all their money.
They are panicking right now. I can feel it.
Look at them.
bonddude's picture

"advise our clients interested in bellies to buy at ...

Mr. Valentine has set the price...

Well done Wiliam, very well done."

Anonymous's picture

I'm derivatives ignorant so pls help: under the ATM trade example, if 30Y rates rise by 300bp to 8.38% in 5 yrs, the trader has made approx 3x? If he does the spread trade, he makes no more than approx 6x?

McGriffen's picture

not necessarily, it's not a linear effect.  For the 5yr ATM, the option should gain if rates move higher above the 5.38% rate or ATM.  But the option will also lose value over time as maturity draws nearer as each month passes (call it a "roll-down" to the final mature date).

Ideally, to me, trade like this works if it can be sold in 18-30 months with rates higher and value remains to the next buyer.  An important wildcard is market volatility, which doesn't lend istelf to a quick "blog" explanatory.  IE, greater levels of volatility in US interest rates could prove beneficial if the trend is to higher rates.

Lionhead's picture

I'm looking to put on the short bond hedge again to protect my corporate bond holdings & pick up additional gains from the hedge. Robertson's put me on to this trade earlier this year & was most lucrative. Short with puts, TBT, or RRPIX depending on one's experience, or use his strategy for a more complex trade.

Looking for a measured move in gold to $1328 out of the massive head & shoulders pattern that's been put in with the neckline breaking this week decisively.

At some point in time, Bernanke's juggling of all markets will fail & the "energy" expended in the manipulation of prices will release in the opposite direction as it always does. Bring it on Ben, I'm waitin' for ya...

McGriffen's picture

thank you for finally posting a comment to the actual point of this column.  Sweet lord, sometimes the gibberish is a tad much.

long afew TBT here...difficult to see the UST 10yr testing 3.0% again with the amount of supply coming.  Inflation is their goal, or seems to be for the FED

Lionhead's picture

McG, I'm waiting for a breakout on TYX to establish the short hedge. Watch that upper TL closely for your trade. Resistance at 4.60%. The 200 sma has provided support for TYX. Good Luck!

On your point of gibberish, what is needed is for folks here to translate the fundamental info into a trade. Information without action is wasted.

McGriffen's picture

Indeed...harumph harumph harumph (Blazin' Saddles scene).  Postings such as this made about out-of-money CMS options might belong under a separate categorical header,like "educational".  Fairly technical information this is

Anonymous's picture

You guy are crazy, why would you want the demise of the US? You will die fighting a battle that was set to win before the first shot fired. Like Clinton said, "No body wins betting against the US"