“Moral hazard is a natural concern for a policy which removes the main risk that hedge funds face when taking leveraged positions in cash-futures basis.” Kashyap, et al, March 2025
The above quote comes from a recent Brookings Papers note, “Treasury Market Dysfunction and the Role of the Central Bank”, authored by Anil Kashyap (University of Chicago), Jeremy Stein (Harvard), Jonathan Wallen (Harvard) and Joshua Younger (Columbia/Tudor Investment Corporation). (See Figures 6 & 7 in Convex Strategies | Risk Update: August 2024 – “Unknowable” for the relevance of their institutional affiliations.)
The authors introduce the note thusly:
“We build a simple model that shows how the incentives and constraints facing three key types of market players – broker-dealers, hedge funds, and asset managers – interact to create a heightened level of fragility in the Treasury market, and how this fragility can become more pronounced as the supply of Treasury securities increases.”
Those who have read last month’s Risk Update Convex Strategies | Risk Update: February 2025 – “Rational Accounting Man” will immediately recognize that the authors have built yet another model based upon our Update’s protagonist, Rational Accounting Man!
Fragility in government bond markets is a long running theme in our ponderings. Those wishing for a recap might want to peruse such past Updates as September 2022 Risk Update – “Is Sharpe World Closing”, in which we link to five other previous Updates all discussing officialdom research and reviews around bond market fragility.
Convex Strategies | Risk Update: September 2022 – Is “Sharpe World” Closing?
“We often discuss the convenient benefit to fiduciaries of the codified acceptance of Sharpe World practices at the expense of end capital owners. The other elephant in that room is the impact that the imposition and universal adoption of Sharpe World principles has had on the ability to create, and find holders for, debt. In no rational investment world would capital owners hold massively proliferating amounts of near zero yielding fixed income securities, as the issuers of those securities, in the case of sovereign governments, extended their debt outstanding balances to and through 100% debt-to-GDP ratios. There can be little doubt that Sharpe World, with its magical sleight of hand that Fixed Income provides a portfolio benefit no matter the circumstance, has been a key driver of the absorption of this explosion of government debt.” Convex Strategies, September 2022.
We carried on with these discussions, re-emphasising our query of “who’s gonna own the 40?”, in the August 2023 Risk Update – “Compounding, Imbalances and the Arrow of Time”.
Convex Strategies | Risk Update: August 2023 – Compounding, Imbalances and The Arrow of Time
We linked in this Update to a Jackson Hole paper from Stanford Economist Darrell Duffie, “Resilience redux in the US Treasury market”. The authors of the Brookings Paper also reference this note in their recent effort.
“In this paper, I describe new empirical evidence, with supporting theory, that the current intermediation capacity of the US Treasury market impairs its resilience. The risks include losses of market efficiency, higher costs for financing US deficits, potential losses of financial stability, and reduced save-haven (sic} services.” Darrell Duffie, August 2023.
This is an especially nostalgic paper for us as it was at a Singapore preview of said paper, prior to Mr. Duffie’s formal presentation in Jackson Hole, that we first coined the term Rational Accounting Man in our own subsequent discussions around said paper.
We clearly stamped our on view on this issue.
“Our view remains the same. The largest uncapitalized risk in the system revolves around this issue of fiscal dominance and financial repression. In the regulatory mathematics of Sharpe World, government debt holding exists somewhere in a spectrum between riskless (eg. 0% RWAs on bank balances sheets) and risk-reducing (eg. LDI Pension investment schemes). Rising back-end interest rates, in debt markets defined by fiscal dominance and financial repression, would appear to us to be the ultimate global fragility in the system.” Convex Strategies, August 2023.
Getting back to the Brookings Paper, the authors focus on one very specific area of Treasury market fragility, the so-called “Bond Basis Trade”. They layout the construction of the existence of this trade along these lines:
- Asset Managers (Pension Funds, Insurance Companies, Bond/Mutual Funds). They class these as liability-driven investors (LDIs) and represent them as needing sufficient bond duration to match their long-dated liabilities but desirous of higher yields from shorter duration corporate debt. Thus, they are users of derivative markets, swaps and futures, as the tool to satisfy their duration appetite. “…asset managers pay the Treasury cash-futures basis for the convenience of holding Treasuries off-balance sheet.” (Our highlight in bold).
- Hedge Funds. The organizations that facilitate the role of inserting their balance sheet (highly levered) as the go between for the Broker-Dealers, who provide the leverage to the Hedge Funds to own cash bonds, as the offset to then provide the derivative liquidity to the Asset Managers, thus earning the spread on the basis between cash bonds, and their explicit leverage, and the derivatives (futures and swaps), and their implicit leverage.
- Broker-Dealers (aka banks). They provide the market making liquidity and balance sheet capacity to absorb interim imbalances in the market. They provide pricing to all of the participants for the various market activities and carry inventory as needed within their own regulatory constraints. They also have access to unlimited, price-constant, funding which they pass on to the Hedge Funds in the form of the repos to fund the levered cash bond holdings.
How much are the Asset Managers giving up for the “convenience”? Using US 30yr Treasury and the USD 30yr OIS Swap Rate, on average over the last 12 years about 60bp per annum.
Figure 1: US 30yr Tsy Yield (white) vs US 30yr OIS Swap Rate (papaya) and the Spread (lower panel) at 95.63 Percentile. March 2020 (red arrow). 2013-March 2025
Source: Bloomberg, Convex Strategies
The fact that this currently stands at the 95.63 percentile probably answers any questions as to why this paper is getting written now. All of the papers and regulatory reviews mentioned above relate back to the ‘blow up’ of the basis in March 2020, which we’ve highlighted with a red arrow above, which necessitated the massive Federal Reserve (Fed) bond buying back then and all the subsequent efforts to figure out what to do next time. As noted in the Brookings Paper, the lessons were quite obviously not learned (or were they?) and the scale of the problem, as noted in the paper, is much larger today – they estimate the size has doubled from where it was prior to March 2020 to something in the region of $1 trillion.
The authors touch on a number of items that have already been discussed, many in the notes that we have linked above.
“How might the Federal Reserve best address such a market-stress scenario? In recent years, proposals have been put forward on a number of fronts, including: (i) adjusting regulations thought to restrict dealer capacity, including the supplementary leverage ratio (SLR); (ii) the creation of a broad-based standing Fed repo facility, by which the Fed could lend directly to hedge funds; (iii) the imposition of minimum margin requirements on repo-financed Treasury purchases; and (iv) a mandate for clearing trades through a centralized counterparty.” Kashyap et al, March 2025.
They then go one to propose an additional safety net – the creation of a specific bond-basis bailout facility for the Fed to provide directly to the Hedge Funds. As opposed to the Fed’s bailouts in 2020 where they just explicitly bought US Treasuries, thus to the author’s disdain clouding the waters between financial stability interventions and monetary policy, they propose a facility where the Fed steps in to the combined cash Treasury and Future/Swap positions of the Hedge Funds in times of stress.
This is of course framed as necessary to avoid financial stability risk issues in another messy liquidation circumstance, not as something to protect said Hedge Funds from extinction. This is where our opening quote around ‘moral hazard’ arises. They brush this concern aside with the simple solution of making sure, ala Bagehot, the bailout comes at some penalty cost to the Hedge Funds such that they do lose some money. Clearly, not so much that it could flow through as credit risk to the repo/leverage providing Broker-Dealers!
“…any remaining moral hazard issues can be partially mitigated with a Bagehot (1873)-like design whereby the Fed stops short of fully insulating the hedge funds from losses while still limiting broader spillovers to the rest of the system.” Kashyap et al, March 2025.
The whole paper/model is just a beautiful example of the simplifications of Sharpe World and the reliance on the only participants that matter, Rational Accounting Man, to follow the incentives as laid out for him.
A few things stand out for their absence. There is never any mention that perhaps there should be more capital/less leverage in the whole process. There is no concept of addressing/reducing the accumulated fragility, just how to clean things up when it gets exposed.
Maybe even more glaring in its absence is any discussion why the whole leverage intermediation chain through the Hedge Funds is necessary in the first place? Why, despite the “inconvenience”, wouldn’t the Asset Managers simply engage in the repo and cash bond purchases/holdings with the Broker-Dealers direct? Wouldn’t the end capital owners, the clients for which the Pension Fund and Insurance Companies are acting as fiduciary, who (presumably) desire the duration, prefer to have the extra 60bp of accrued annual earnings compounding into their own capital? Wouldn’t the Pension Fund or Insurance Company, that has the actual capital with appetite for the duration risk, be less risky for the system as the counterparty for the explicit leverage provided by the Broker-Dealer?
The answer to those questions, inevitably, brings us back to the usual suspect of manipulating Rational Accounting Man to behave as layers and layers of rules and regulations incentivize him to do. It is, at its core, financial repression. It is how fiduciaries get utilized to own, with maximum fragility creating leverage, government debt. Done with other people’s money, at prices that no reasonable capital owner (Boundedly Rational Agent) would allocate to. It really is the perfect example of how the manipulations, by the keepers of Sharpe World, of Rational Accounting Man, build the fragilities that create the imbalances that generate the busts.
It begs for the wonderful comic that we included in our July 2024 Update – “Chaos” Convex Strategies | Risk Update: July 2024 – Chaos.
Source: The problem with problem-solving is slowly destroying the world (wholebraininvesting.com)
It is moral hazard at play, necessitating more moral hazard.
Lest we think this is only a US Treasury problem, we should have a glance around the other active participants in what we have dubbed the Hunger Games of bond issuance.
There are plenty of Bond-Basis shenanigans going on in Japan. The below chart shows the basis between the 30yr JGB and the 30yr Interest Rate Swap is at the 99.67 percentile over the last 12 years. Just about ready to mean revert, or stretched to breaking point?
Figure 2: JGB 30yr Bond Yield (white) vs JPY 30yr OIS Swap Rate (papaya) and the Spread (lower panel) at 99.67 Percentile. 2013-March 2025
Source: Bloomberg, Convex Strategies
How about in the land famous for its LDI challenges in 2022, the UK? Just eyeballing figure 3, we can see that the 30yr basis is much wider and the outright 30yr Gilt yields are much higher than back when the Bank of England (BOE) had to jump in and support the Gilt market in 2022.
Figure 3: UK Gilt 30yr Yield (white) vs GBP 30yr Swap Rate (papaya) and the Spread (lower panel) 99.65 Percentile. 2013-March2025
Source: Bloomberg, Convex Strategies
The authors note, in the case of the US Treasury market, that the Bond-Basis has been consistently positive but only since the Great Financial Crisis (GFC) and they don’t really explain why that previously wasn’t the case. We can see above that the same has been true for JGB and Gilt markets.
An exception to that story is the Eurozone. We have used just the Generic Euro Government bond for figure 4, and we can see that for virtually the entire 12yr period it has had a negative basis. We also see that, like the other market above, it is now positive and screaming higher.
Figure 4: EUR 30yr Govt Bond Yield (white) vs EUR 30yr Swap Rate (papaya) and the Spread (lower panel) at 99.62 Percentile. 2013-March 2025
Source: Bloomberg, Convex Strategies
We could almost make a supposition that there is somehow an emerging limited balance sheet capacity to hold physical cash bonds in Europe. Our stubborn-minded explanation would come back to our Hunger Games analogy and conjecture back to our discussions of Comrade Draghi’s famed report of “The future of European competitiveness”. We discussed this to some length in our September 2024 Update – “Emergence” Convex Strategies | Risk Update: September 2024 – “Emergence”. The vastly simplified version is “we need to borrow more money and spend it on what we think is important”.
This concept got an unprecedented boost in March when the (outgoing) German government announced that they would be having a speed vote to repeal the so-called Debt Brake from the constitution and embark on the eventual issuance of something in the region of a fresh EUR 1 trillion of German Bunds. Hunger Games, baby!
Exclusive: Germany weighs special funds for defence and infrastructure, sources say | Reuters
“The parties in talks to form Germany’s new government are considering quickly setting up two special funds potentially worth hundreds of billions of euros, one for defence and a second for infrastructure, three people with knowledge of the matter told Reuters.
Economists advising the parties that will likely form a new government coalition estimate around 400 billion euros ($415 billion) are needed for the defence fund and 400 billion to 500 billion euros for the infrastructure fund, the people said.”
“… the hope is that the funds would be approved in March during the current parliament before a new government is formed.”
The plan was announced on March 2nd and the plan was passed by the outgoing parliament on March 19th, less than one week ahead of the newly elected parliament convening on March 25th. Democracy with European characteristics.
Germany’s parliament passes historic package boosting defence spending | Euronews
“Germany’s parliament on Tuesday passed a historic bill unlocking a record level of state borrowing for defence and infrastructure through amending the country’s constitutionally enshrined fiscal rules.”
“Merz faced a tense race to push the proposal through ahead of the new parliament convening on 25 March, where the far-left Die Linke and far-right Alternative for Germany (AfD) would have the ability to block the package.”
Just what the Hunger Games arena needed, a fresh competitor in the form of one of the last previously deemed-prudent borrowers left amongst all the districts. The mouthpieces of Sharpe World praised the coming fiscal surge with great enthusiasm, while the Bond-Basis surged ever wider.
In all of the above markets, the once biggest providers of demand for bonds, i.e. the respective central banks and their various forms of QE, ceased doing so with their various moves to taper and then QT – circa 2022 for Fed, BOE, ECB, then 2024 for BOJ. It is easy enough to pinpoint the impact that has had on their respective Bond-Basis outcomes.
Fed Chair Jerome Powell has seemingly taken some of that to heart and at the March FOMC announced a significant reduction in the already snail-like pace of the Fed’s QT (moderate bond run-off).
Federal Reserve Board – Federal Reserve issues FOMC statement
“Beginning in April, the Committee will slow the pace of decline of its securities holdings by reducing the monthly redemption cap on Treasury securities from $25 billion to $5 billion.”
This despite the official FOMC statement that all is perfectly well.
“Recent indicators suggest that economic activity has continued to expand at a solid pace. The unemployment rate has stabilized at a low level in recent months, and labor market conditions remain solid. Inflation remains somewhat elevated.”
We were lucky to come across this little slide presentation from a member of the Fed’s distinguished staff, Roberto Perli.
Roberto-Perli-Mar-2025-slides.pdf
We found this slide, now figure 5, particularly telling. As we have often discussed, former Treasury Secretary, Professor Yellen, shifted an increasing share of issuance to the front end of the Treasury curve. This can be seen below with the large, circa 22.5%, share of Bills issuance relative to the other tenor buckets. The Fed, on the other hand, has clearly not matched their holdings to the tenor proportions of the Treasury’s issuance. The Fed has a significantly disproportionate amount of their holding, circa 25%, in the 10-22.5y bucket. The Fed’s QT has been a notional-based gradual decline, not a duration-based decline. One could certainly surmise that the Fed has been trying to aid the Treasury in the management of the dearth of market appetite for duration bonds. We might point to this and claim that the Fed continues to provide a modicum of support to the Treasury in coping with the problems of excess debt and fiscal dominance. Problems that, many would claim, the Fed has played a key enabler role in their formation.
Figure 5: Fed Balance Sheet vs Treasury Issuance
Source: Federal Reserve Bank of New York, US Dept of Treasury
Trying to fix the problems created when they were trying to fix the problems…..
Transcript of Chair Powell’s Press Conference – March 19, 2025
Chair Powell mentioned in his comments at the subsequent press conference that the FOMC had further discussed issues around the ongoing monetary policy framework review. We shared our thoughts on this in some detail in our November 2024 Risk Update – “Rationality Wars” Convex Strategies | Risk Update: November 2024 – “Rationality Wars”. We aligned ourselves with many of the comments Claudio Borio made in his departing speech from his role as Head of the BIS Monetary and Economics Department.
Whither inflation targeting as a global monetary standard?
We shared several quotes from Claudio’s wonderful speech, but this one makes the point clearly.
“Lower rates could, over time, encourage further indebtedness, which would in turn make it harder to raise rates without causing damage to the economy.”
Just a simple sense that actions have consequences, history matters, initial conditions can have unforeseen consequences.
For a different perspective, we can refer you to more works from the good people at the Brookings Institution and three Brookings Papers covering the Fed’s framework review. For those who wish, you can download all three papers at this link to their website.
The Federal Reserve’s monetary policy framework review
These are very much papers in the Sharpe World tradition, questioning why things didn’t work as foreseen and proposing moderate tweaks in hope that Rational Accounting Man will march in step going forward. All three papers give a review of the previous framework from 2020 then some proposals for how the Fed should consider adapting in their new framework.
Just some quick comments on the three:
First up and arguably the best of the three, “Challenges Around the Fed’s Monetary Policy Framework and Its Implementation” William English and Brian Sack.
“We conclude that the changes to the framework were too focused on the experience following the financial crisis and hence were not robust in the face of unexpected changes in economic circumstances.”
This paper is critical of the previous framework in that it was locked into the circumstances of the time and did not allow for flexibility in a changing environment.
“This guidance turned out to be too aggressive, given how economic conditions evolved… However, it is important to note that the policy guidance did not appear too aggressive at the time it was implemented.”
Even when criticising, they are ever so gentle.
“QE generally has three purposes that could be considered: 1) to signal about the future path of short-term rates, as an adjunct to forward guidance, 2) to reduce term premiums and loosen financial conditions through the portfolio balance channel, and 3) to improve market functioning during periods of market stress. In short, we believe that 1 should be crossed off the list, and 2 and 3 should be more clearly differentiated.”
We think 1 and 2 should probably be crossed off from the list.
In the end, they just think the whole thing should be more flexible and not tie the hands of the great orchestrators at the Fed.
“The framework should allow for the policymakers to respond, while taking appropriate account of their assessments of the costs, benefits, and risks.”
The second paper, “Considerations for a Post-Pandemic Monetary Policy Framework”, from former Chicago Fed President Charles Evans, is by far the worst we think. Unlike the other authors, Mr. Evans was actually involved in implementing the 2020 framework. That may have something to do with his Philip II of Spain-esque demeanour of “no experience of the failure of his policy could shake his belief in its essential excellence”. The title alone shows the author’s effort to frame the whole circumstance as having been the fault of the unforeseeable exogenous event, i.e. the pandemic.
“While the 2020 framework remains a sturdy foundation for monetary policymaking, I discuss implementation issues and suggest a few improvement opportunities that may help combat the challenges arising from the choice of a low 2 percent inflation objective.”
“Finally, although I argue that the 2020 LR framework remains a sturdy strategic foundation with only minor cracks (if any), the Fed’s upcoming framework review does point to a number of improvement and clarification opportunities.”
Once again paraphrasing Mr. Taleb, without accountability there can be no learning.
Finally, paper number three, “Did the Federal Reserve’s 2020 Policy Framework Limit Its Response to Inflation? Evidence and Implications for the Framework Review”, from Christina and David Romer. This one gives a bit more of an overview of the previous framework and broadly comes to a similar conclusion as the first paper, just be more flexible.
The authors focus their criticism on just two aspects of the previous framework, the elevation of the employment mandate and stepping back from pre-emptive actions.
“Our key finding is that the elevation of the maximum employment side of the dual mandate played a crucial role in limiting the Fed’s response to inflation… Policymakers appear to have felt bound by the forward guidance that said meeting both the inflation goal and the maximum employment goal was crucial.”
“The framework review should seek to revise the strategy to be more general and flexible.”
“Finally, because monetary policy works with a substantial lag, pre-emptive monetary policy actions are not only appropriate, but necessary.”
None of these give us much hope that anything fundamental is going to come out of this framework review. There is certainly no questioning of the Fed’s role as a shaman and manipulator of outcomes, no sense that the whole thing may be a Complex Adaptive System, and they have no basic understanding of what they are doing.
We will stick with our view that risk is endogenous, and it is the very manipulations of Rational Accounting Man that generates the boom-bust cycle that the great central planners fail to predict. We stick with our simple view of risk. It is not the inevitable but impossible to predict exogenous shocks that define risk, but rather the accumulated building of fragility. Our oft referenced below chart of EUR 25delta FX butterfly costs, with red lettering of the unforeseeable exogenous events and red circles of the endogenous risk build ups, is a useful illustration.
Figure 6: EUR FX 9mth 25delta Butterflies. Exogenous Shocks (red letters). Endogenous Risk (red circles). 2008-March2025.
Source: Bloomberg, Convex Strategies
From a risk and investment management perspective, we will forever harp on about the same thing: build convexity into your portfolio. Improving the geometric compounding path of investments through time is not about predicting the future. It is about building resilience in your portfolio to divergences from expected outcomes. It is about how your portfolio performs when you are wrong, not when you are right, that will make all the difference.
Sadly, we see a whole bunch more work advocating for bad solutions than we see advocating for good ones.
Our friends at the CBOE came out with this well-presented report under the worthwhile auspices of what can be done to overcome the shortcomings of bond holdings in the traditional 60/40 bond portfolio. Unfortunately, we would observe that they have played any number of Sharpe World games to then advocate for solutions that do not result in improved risk-adjusted compounded returns.
go.cboe.com/l/77532/2025-03-14/fm26jx/77532/1741955572lZrgZERH/Beyond_60_40.pdf
Just a quick run through of some of the tactics targeted at Rational Accounting Man that those of you aspiring to be Boundedly Rational Agents should be on the lookout for.
Their presentation simply proposes replacing 20 out of the 40 allocated to bonds in a traditional 60/40 portfolio, to two possible alternatives in their “Buffer Protect” strategy as represented by their own SPRO Index (an index that tracks owning the SPX while undertaking a collar trade of selling a topside call to fund the downside purchase of a put spread) and an “Income Strategy” represented by their BXMD Index (a buy-write index that tracks owning the SPX and selling topside calls).
This first chart, comparing the SPRO Index to the SPX Index is an example of narrowing the range to mask where the potential costs and risks actually reside which is in the “wings”, the infrequent but high magnitude occurrences that truly drive geometric compounding. The SPRO Buffer Strategy is only protected for the first 10% of market downside (it has bought a 100%-90% put spread) and only participates in a max of 12% of the market upside (it sold a 112% call). Were they to widen this presentation outwards for +/- 30%, 40%, 50% market moves the potential buyer would see that he is giving up all further potential upside (the positive blue box on the right would not get bigger) while the downside would continue to grow step for step with the market downside, after the initial 10% of protection. In the end it would just look like some form of written put.
Figure 7: Narrow Scenario Range: Hypothetical SPRO Index vs SPX Index
Next up what we would deem to be the Sharpe World sins of annual arithmetic performance using Sharpe Ratio and a risk-adjusted return metric. Neither of these are useful metrics for end capital owners, both are only relevant in the realm of Rational Accounting Man. For Boundedly Rational Agents these should both be immediate red flags. They are now comparing their traditional 60/40 (they have used SPX Index and the Bloomberg US Agg Index) with their rebundled 60/20/20 SPRO.
Figure 8: Annual Performance and Sharpe Ratio of Hypothetical 60/40 vs 60/20/20 SPRO
They do the same again for their repackaged 60/20/20 BXMD.
Figure 9: Annual Performance and Sharpe Ratio of Hypothetical 60/40 vs 60/20/20 BXMD
They then tell you how many years one outperformed the other by these metrics, which we would argue is totally meaningless to the capital owner, but do finally get to the one picture that does have meaning, the cumulative compounding view over time. We’ve replicated this to make it a little bit clearer.
Figure 10: Hypothetical Cumulative Returns of 60/40 vs 60/20/20 Buffer vs 60/20/20 BXMD 2006-Feb2025
Source: CBOE, Bloomberg, Convex Strategies
That is a little bit better but what have they actually done? They’ve simply added a greater equity weighting, but with limited upside participation, during a period of exceptionally strong market performance. What they have not done is make any attempt to risk equalize the strategies.
We can easily throw in a couple of the more obvious examples available, roughly equalize them to the downside volatility (a useful measure of risk) and see how it looks. First, per our above comments, let’s just add more equity weightings and put the rest in bonds and see how it performs. That happens to shift our 60/40 to a 74/26 weighting. Second, while the CBOE seems to like to ignore them, we are big fans of their Put Protect Indices! Let’s follow their same bond substitution methodology and construct a portfolio where we replace a portion of the bonds in the old 60/40 with the CBOE PPUT3M Index (this one owns the SPX and buys 3mth put options outright), adjusting the weightings to again get a roughly similar downside volatility. That now looks like this.
Figure 11: Hypothetical Cumulative Returns of 60/40 vs 60/20/20 Buffer vs 60/20/20 BXMD vs 74/26 vs 60/13/27 PPUT3M. 2006-Feb2025
Source: CBOE, Bloomberg, Convex Strategies
What do we learn? Their original proposed strategies of replacing half of the bond allocation with their SPRO and BXMD indices is indeed no different than just dialling up the equity weighting and owning fewer bonds. The newly constructed 74/26 balanced portfolio, equalized to the downside volatility of the ‘Buffer’ composition, is no different than the two CBOE recommended alternatives. We also learn that their own Put Protect strategy allows us to own a lot fewer bonds, likely due to the benefit of the downside equity protection embedded in it and end up with the superior overall risk-adjusted performance.
We are always disappointed when the CBOE ignores its own Cinderalla-like stepchildren, the Put Protect Indices. You can sort of eyeball in the above charts that the dispersion and volatility of the lines in the compounding paths starts to pick up sort of around 2018. It is pretty easy to zoom in on that period and just go to Bloomberg to see the relative performance of the three CBOE indices.
Figure 12: PPUT3M (blue) vs SPRO (white) vs BXMD (orange). 2018-Feb2025 (normalized)
Source: Bloomberg, Convex Strategies
As we always like to point out, the above chart only represents what DID happen. Throughout the entire period, the Put Protect strategy always had the potential for more upside participation, had it unexpectedly materialized, and the protection against more severe downside shocks, had something unforeseen jumped out of the closet.
The advocacy of these types of short convexity strategies is ubiquitous in the world of finance, the world of Rational Accounting Man. The question we should all ask is, why is that so? If every major player inside Sharpe World is advocating that capital owners forego convexity in their investment strategies, and is adamant that it is the best profitable investment path, what is happening to them on the other side of all that foregone convexity?
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