Credit Where It's Due

An Interview with Boaz Weinstein

Boaz Weinstein, the founder and CIO of Saba Capital, is regarded as one of the foremost credit traders in the world. He made news when he harpooned the so-called London Whale, getting on the scorned but eventually victorious other side of Bruno Iksil’s massive derivatives trade. His reputation as a brilliant and unorthodox player in high yield (and nowadays not-so-high yield) is deeper, widespread, and well-deserved. Here, he explains his thinking on how to take advantage of historically low levels of volatility, the seeming deafness of the credit market to nightmarish equity signals, and getting into the closed-end fund business.

, says Boaz Weinstein.

Hertz is a great way to play a rise in volatility, says Boaz Weinstein.

Octavian Report: Is this the lowest you've ever seen volatility in the market?

Boaz Weinstein: On June 9th, the VIX touched 9.45. Since the beginning of the VIX -- January 1990 -- or roughly 7,000 days ago, I think this is the second-lowest level.

However popular, the VIX is not the only way to talk about volatility. It would be fair to say across markets, implied volatility and realized volatility are as low as they have ever been in anyone's career. There have been brief moments where levels were similar, but the environment today is perplexing. Equity markets have rarely been this expensive and it has never been less costly to protect the downside -- a surprising combination.

In 2016, there were enough events along the way -- notably the energy-led selloff and Brexit -- so that when you average it out, it was kind of a 50th-percentile year with an S&P realized volatility of roughly 13. In 2017, we've gone to effectively the lowest ever with realized volatility dropping to seven. This is a far more surprising post-election result than the rally in equity markets. Even though plenty of notable managers were calling for a stock drop in the event that Trump would become president, the rally wasn’t a total shock. Realized volatility back to 1963 lows is a true bolt from the blue, given the significant amount of economic and political uncertainty that comes from a new administration plus all of the unknown-unknowns, to coin a phrase.

Some of it is technically driven. There are sellers of volatility that look at it as an attractive carry trade since the credit market offers so little carry at present. Others, such as volatility control funds, sell volatility as it goes lower to keep a constant amount of exposure. So yes, these entities are to some extent depressing volatility. Now, there’s that famous quote: "No matter how much tornado insurance you sell, you're not affecting the odds of a tornado, but if you sell enough portfolio insurance. . .” That said, this dampening effect can reverse if a significant event causes volatility to rise, since some of these funds will be falling over themselves to cut their positions in that scenario.

I think the energy selloff last year is a good example, where so many people were early in liking energy bonds that had fallen from 100 to, say, 75. Venerable funds with long-dated capital were set up to take advantage of the energy opportunity. Finally, when oil fell enough that the dip in energy bonds was not viewed as a buying opportunity, some of the buyers actually became sellers, especially as a lot of risk these days in credit is held in daily liquidity mutual funds, ETFs, and so forth.

I think with volatility it’s the same story. For now, there's probably a lower chance of a breakout in volatility, but if there is one, it will be much more severe because you have all of this short interest.

OR: What is on the top of your list for potential triggers?

History has shown that investors, ourselves included, are not good at all at spotting regime shifts in advance. You can see it in the way the VIX almost always spikes on a large rise, but comes down gradually. People don't see the event ahead of time, and when you consider that at present there is a large divergence between the calm in markets and the almost unprecedented amount of political and economic uncertainty, I think even without a catalyst in sight, owning portfolio insurance and owning volatility are incredibly compelling.

OR: How far out can you go with exceptionally low volatility?

Weinstein: In the U.S. the phenomenon of low implied volatility really is only short-term out to three months. After that, the levels become less attractive. Eventually, out to two to three years, implied volatility is actually over double the level of recent realized volatility.

The most undervalued long-dated equity volatility is in Asia, particularly in China, Japan, and Korea, thanks to an incredibly successful campaign by the banks to sell bonds that are linked to the price of equity indices. They are made to look a lot like a generic high yield bond -- they pay coupons every six months and are issued at par by well-known banks -- but their ultimate redemption at maturity is tied to whether the Nikkei or Hang Seng China Enterprises Index or Kospi have declined. The success in placing these structures with small institutions and high net worth investors is also symptomatic of the global problem of low yield in fixed income. Investors in Japan, for instance, are yield-starved given near-zero percent rates for JGBs and an aging population. So it’s no surprise that the structures sell well given the optics. But if you decompose them, it’s apparent that the investor’s yield is coming almost entirely because they sold out-of-the-money puts on stocks. I think there is a suitability question for these products and in a bear market I fear that these same sellers of volatility will be the ones buying it back at peak.

The tenors of these bonds can range out two to five years, and that has really suppressed long-dated volatility. Even though in almost every environment for the past decade (including 2008), the U.S. was less volatile than, say, the HSCEI, one can buy long-dated Asian equity vol at only a tiny premium to where the equivalent S&P vol is trading. This corner of finance may be new for some Octavian readers, and I think it’s really worth paying attention to, because it's one of the places where I see great complacency in markets.

OR: Your fund has focused on the apparent disconnect between the credit market and the equity market; capital structure arbitrage, more or less. Can you talk about that and about how it’s a way of playing the volatility?