Bernanke Begets $602,000 Risk-Free Bond Profits in ChileSebastian Boyd
Ben S. Bernanke has inadvertently created the biggest arbitrage opportunity in the Chilean bond market in 20 months.
Yields on Chile’s $750 million of bonds due 2022 surged to a record 3.71 percent yesterday, part of a global rout as the Federal Reserve Chairman mapped out a timetable for the end the bank’s unprecedented bond buying this week. With the sell-off, an investor who buys $10 million of the bonds and converts them to pesos using cross-currency swaps would get 0.61 percentage point more in interest than similar-maturity local notes. That would provide an extra $602,000 by the time the bonds mature, according to data compiled by Bloomberg.
The last time valuations of Chile’s dollar-denominated bonds fell so far out of line with local fixed-rate debt was in October 2011 as European leaders debated a bail-out for Greece. The distortions in the nation’s bond market are amplified because only three percent of Chile’s local notes are held by foreigners, shielding them from the global capital flight. Historically, yields on dollar bonds have been 0.19 percentage point lower than local notes after swapping.
“It is becoming more attractive to buy in dollars and swap to pesos,” said Rodrigo Blazquez, a swaps trader at Deutsche Bank AG in Santiago. “The pain has been felt more in derivatives where there are more offshore investors. There shouldn’t be much flow of sales in local bonds but we are seeing flows in the swaps.”
The yield on Chile’s dollar bonds due in 2022 rose 108 basis points, or 1.08 percentage points, in the past month. At the same time, 10-year peso bond yields climbed 32 basis points to 5.4 percent.
The 10-year swap spread, or the gap in yields between bonds and swaps, rose 39 basis points, or 0.39 percentage point, to 19 basis points yesterday from minus 20 basis points on May 9. The difference reached 23 basis points on June 4, the highest since the aftermath of Lehman Brothers Holdings Inc.’s bankruptcy in 2008.
Chile’s 10-year swap yields have soared almost twice the increase on peso bonds in the past month, climbing 58 basis points to 5.57 percent.
Mexican swap spreads have also widened. The five-year swap spread in Mexican pesos climbed 24 basis points to 90 basis points on June 19, the highest since October 2008. The yield gap between Mexico’s dollar bonds due 2022 and its similar-maturity peso notes after swapping widened 30 basis points to 93 basis points June 20, when Bernanke said the Fed may start phasing out quantitative easing, or QE.
The extra yield an investor could get from buying a 10-year Chilean bond and swapping it into inflation-linked notes instead of fixed-rate debt also reached 0.64 percentage point yesterday, the highest since 2008, according to Bloomberg calculations. That gap is almost three standard deviations from the mean of the past five years, meaning the likelihood of it occurring over that span is less than 0.3%
“It’s more attractive today to buy abroad than in Chile,” said Valentin Carril, who oversees $5 billion as the chief investment officer of Principal Vida Chile in Santiago. “Normally, they move in the same direction, but spreads have moved differently. It’s something we haven’t seen very often before.”
Yields on Chile’s 10-year peso bonds have climbed 0.32 basis points to 5.4 percent in the past month, according to data compiled by Bloomberg. That compares with a yield increase of 117 basis points on peso notes due in 2024 from Mexico, where foreign investors own 56 percent local fixed-rate debt.
Felipe Alarcon, an economist at Banco de Credito & Inversiones in Santiago, says the surge in Chilean dollar bond and swap yields as well as its credit-default swaps will be short-lived.
Chile’s five-year credit-default swaps, a measure of the cost of protecting the nation’s dollar debt against losses, rose to 113 basis points as of 3:51 p.m. today in New York from 72 basis points a month earlier.
The jump in swap yields also indicates that traders now expect the central bank to leave the benchmark interest rate on hold at 5 percent at the next meeting, cut it to 4.5 percent by yearend before raising to 4.75 percent in April, according to Banco de Chile data.
“That doesn’t make much sense,” Alarcon said. “It’s a clear sign of overshooting. The same is true of the country risk. The risk of default hasn’t changed. What we have seen is a capital flight back to the U.S.”
As recently as June 19, they predicted the bank would lower the rate to 4.75 percent in July and again in the next following three months.
The extra yield investors demand to buy Chile’s 10-year dollar bonds instead of U.S. Treasuries fell five basis points to 140 basis points today after surging 42 basis points yesterday. The Chilean peso appreciated 0.5 percent to 511.67 per dollar today in Santiago, after falling 2.8 percent yesterday.
Sebastian Ide, head of rates trading at Banco de Chile in Santiago, said that while the jump in swap yields creates an arbitrage opportunity for investors, it means that it’s more expensive for companies to sell debt in dollars and exchange those dollars for pesos.
“Today the idea of issuing abroad doesn’t make sense,” he said.