See below for a visualization of the top 15 cryptocurrency prices (in terms of market capitalization) over the last two years. The green bar represents the aggregate market capitalization of the top 15 tokens combined. Make sure to check out December 2017!
Since the inception of Bitcoin and the concept of ‘digital assets’, institutional and retail investors kept their distance (and rightfully so) given the extreme volatility in prices, uncertainty around regulation, and questions around consumer adoption. Not only was the concept of Bitcoin foreign, but potential opportunities surrounding the digital currency and its underlying technology were also quite nascent.
As investors and entrepreneurs increased attention and resources to trading, mining, and building tangential services around these digital currencies, we have witnessed a bumpy road to stabilization and maturity. A study of market cycles demonstrates the relative boom and bust of any new industry. A particular article in Hackernoon shows a great example of this by overlaying BTC prices on stock market performance during the inflating and pop of the dotcom bubble.
In order to attract capital and accelerate a new growth cycle, trading statistics of cryptocurrencies need to be more in line with traditional asset classes. Evidence of that trend has already been reflected in trading price data. Analyzing the trading data of the top cryptocurrencies (based on market capitalization), a decline in 30-day rolling volatilities and significant compression in the volatility spread between BTC with the S&P 500 and Russell 3000 indices were observed.
While there is certainly a long way to go until the industry begins to “mature” (with respect to long term cycles), the sharp decrease in implied volatilities points to certain tailwinds.
First, there have been a plethora of services and applications built with blockchain tech and successful companies in the space are now emerging. Payment services companies such as BitPay demonstrate various applications focused on consumer and business adoption. Ripple’s partnerships provides further evidence that there are tangible results that will disrupt status quo tech. The Zerocoin project has improved its capabilities and made meaningful progress towards secure transactions.
Finally, large multi-national corporations are beginning to introduce new and specialized product lines for industry participants. For example, Samsung released a new chip to improve BTC mining profits. These new products will reduce the overall marginal cost to enter related markets, just as cloud computing decreased the capability gap between small and large corporations.
While we cannot ascertain where the winners will be (equity investors, miners, coin investors, etc.), there seems to be a long runway for investors and entrepreneurs to figure it out. What we can see is that the railroad is making its way to the wild west, both the numbers and trends point to opportunities for those paying attention.
After the recent collapse of the cryptocurrency bubble, the appetite for institutional capital in the blockchain industry is still low, but there is an intensified focus on corporate governance, legal structure, and project teams. Investors looking to structure deals in the space need to implement appropriate methodologies for valuation and corporate governance to attract investors and create sustainable investment platform. EY’s recent study that 66% off ICOs are in the red has only increased the necessity to implement a systematic and conservative approach to investing in the space.
Don’t be caught off guard setting up proper controls for valuation policy & procedures. New valuation models such as the INET or NVT models require the assistance of experienced professions that are at the forefront of industry. Please reach out to Intrinsic today for more information!
Private Equity Checklist for Investing in the Blockchain Industry
In this lesson, we will discuss using futures data to predict changes in the federal funds rate. Changes in the federal funds rate have a critical impact on the yield curve, value of bonds, and economic growth. While this discussion will not go into depth for those topics, it will help you understand the relationship between investor expectations and how you can safeguard your portfolio.
The first step in predicting interest rate hikes is to gather information about current prices from the Federal Reserve and investor expectations from futures prices on the 30-day federal funds rate. In order to understand why futures are useful, please review the following:
Now, let’s start the process of gathering the data to make predictions! We are going to start with acquiring data from the Federal Reserve website. Specifically, we are looking for the current target rate set by the Fed. This is usually in the latest minutes released by the Fed. If we navigate to the FOMC calendar on the Fed’s website:
Find the last FOMC meeting and review the PDF, the header and relevant sections can be seen below:
Here, we can see that the current target federal funds rate is 1-1/14 (meaning 1.25%). The next step is to find the latest futures price on the 30-day federal funds rate futures. We first navigate to the CME group site for the 30-day Federal Funds Rate (the easiest way to do this is to just google that term).
This page shows the current quotes; however, we want a more stable figure to help us in our analysis. Click on the Settlements to see finalized settlement prices from the prior business day.
Here, we can see that the last settled price is 98.8425. According to Robertson and Thornton (Click here to access paper), the futures quite can be thought of as the average price for Fed funds in a particular contract month.
In this case, the implied yield on the federal funds rate can be calculated as 100 – 98.8425 = 1.1575%.
The last piece of the puzzle is to note the date of the next FOMC meeting and select the appropriate futures instrument. Above, we have selected the November futures price (although this should usually be determined afterwards). Looking at the FOMC calendar meeting, we observe that the next FOMC meeting is October 31, 2017. Therefore, we selected the futures instrument with the nearest maturity to the next FOMC meeting, and represents the most relevant instrument to gauge investor sentiment.
Putting it All Together
Using this information we gathered, we can apply Geraty’s formula to determine the probability of an increase in a federal reserve hike (click here to access the article). The other key factor is what the expected rate hike will be. Based on the information above, we see that the implied yield of 1.1575% exceeds the federal funds rate target of 1.25%; therefore, we can determine that investors are not expecting an increase in the federal funds rate. Instead, let’s examine a 25 basis point reduction.
The formula is presented below, in addition to the application of the inputs gathered above.
Based on the analysis, there is an 8.0% probability of a reduction in interest rates. From an investor’s perspective, this implies that the federal funds rate is unlikely to change at the next FOMC meeting!
Keeping in mind there are adjustments to be made to the formula (read the literature I have posted links to!), this is a simple way to gauge investor expectations. This strategy becomes even more powerful when combined with your own interest rate projections, topics we will cover at a later date!
Today, we will talk about the concept of duration. The discussion will include a basic overview of the concept of duration, different methods to calculate duration, and how to incorporate duration into both strategy and risk management.
What is Duration?
Duration measures the sensitivity of a bond’s price to changes in interest rates. Since bond prices have an inverse relationship to bond yields, an increase in interest rates will reduce a bond’s price (and vice versa). For a more basic overview, please visit “Bond Investing Basics – Setting Your Goals” for links related to basic bond concepts. Duration measures (or, more precisely, attempts to estimate) the magnitude of that change.
How to Find Duration
Most brokerage firms that allow you to trade bonds have both screening tools and tearsheets in order to find a suitable bond based on the desired level of duration. Below, I have used the E*Trade platform to find for a position’s duration. First, click on Trading –> Bonds to pull up the Bond Overview page.
In the box labelled “CUSIP,” (CUSIP stands for Committee on Uniform Security Identification Procedures and represents a 9 digit identifier for bonds) type in any identifier for the bond. For the purpose of this post, we have used the CUSIP “665859AL8,” which is a CUSIP for a bond issued by Northern Trust Corp.
From here, click on the actual issue (in this case, it is clicking on “Northern Trust Corp” in the Issue column) to bring up further details on this specific bond. Looking at the bottom right, you can see the Macaulay duration to be 2.848.
There are a few different measures for duration outlined on this page (in addition to convexity, which we will not be covered today), that we will cover in a later post. The duration figure represents the number of years it will take an investor recover the cost of a bond (after accounting for discounting, the purchase price, and remaining cash flows). The higher the duration, the higher the interest rate risk. Generally speaking, a bond’s duration will be higher with:
Higher interest rates
Lower bond prices
One general strategy is to consider where interest rates are expected to move in the future. If an investor expects interest rates to move up (hence, prices to move down), he or she may consider “shortening” duration in order to reduce interest rate risk. This will make the bond portfolio’s value to be more resilient to increases in the interest rate. If an investor expects interest rates to decline (hence, price move up), he or she may consider “lengthening” duration in order to take advantage of a bond’s sensitivity to interest rates. The most sensitive the portfolio is, the more likely that the bond’s price will move up.
The first step in the process is to determine what you can benchmark your portfolio to. There are several different benchmarks released by companies such as S&P, Merrill Lynch, etc. In addition, the benchmarks can be tied to the tenor of bonds, industry, credit rating, structure, etc. Using more specific benchmarks can help investors tie their performance and uncover key drivers of under or over performance. As an example, for the purpose of our post, we will be using the general S&P US Aggregate Bond Index (click here for the S&P summary page). As indicated in the name, this index represents broad coverage of US-based investment grade fixed income. First, click on “Factsheet” and then download the Month-End report.
After, flip to page 3 of the downloaded document where you can find the index characteristics below:
As you can see, when comparing to the Northern Trust Corp. specific data, the general US investment grade market has a higher duration (5.50 versus 2.848). While we have just used the duration figure here, you will be able to benchmark a few factors relative to the general index (such as yield, tenor, etc.). A more appropriate benchmark to Northern Trust Corp. may have a portfolio duration closer to the subject company.
This model is intended to provide a broad view of how to manage duration risk in a portfolio. We start off with noting key elements of your bond portfolio (such as the invested amount, price per bond, maturity date, and the coupon rate). The model automatically calculates the duration (using the Macaulay formula) and the implied yield on the bond. After all the individual data has been input, the model will calculate the portfolio figures in the bottom row:
From here, we can calculate potential changes to each position. Changes in the price, based on the duration of the bond is generally presented as:
Change in the Bond Price = Duration * Change in Yield
The sensitivity table below shows the percentage changes in the bond price based on assumed changes in interest rates:
Based on this analysis, investors can choose whether or not they need to adjust the portfolio for expected changes in the interest rate in the future (i.e., to take advantage of declining interest rates by lengthening duration or vice versa).
Just to note, the model is a simplified tool. In order to truly understand your portfolio, adjustments would need to be made for:
Amortization or cash flow sweep payments (the model assumes a bullet payment)
Interest Payment dates if anything other than quarterly payments
Call or Put options embedded in the bond structure
Another way to look at the model’s output is to determine the total dollars at risk. If you expect for rates to decline 2% over the next year, you can see the potential impact to your portfolio. Investors can find ways to hedge the portfolio or change strategy. Again, investors need to pay attention to their specific strategies; the model is just a tool to help you along the way!
Duration is a foundational concept to understand when building your bond investment strategy. Bonds have a built-in structure that enables investors to have more clarity relative to general equity investments. Taking advantage of these structures may be difficult to understand, but are rewarding to figure out!
Today’s lesson will focus on credit ratings and how to utilize them in order to manage your portfolio and potentially select strategies that will enhance returns.
Credit Rating Definitions
There are generally two credit rating agencies that investors pay attention to: Standard & Poor’s and Moody’s. Credit rating categories range (in the case of S&P) from AAA (highest rating) to D (lowest rating). See below for each company’s credit categories and corresponding definitions:
One important consideration is the separation of “investment grade” and “high yield” bonds. Investment grade bonds (categorized typically as AAA through BBB rated bonds using the S&P categories and Aaa through Baa3 using the Moody’s categories) are generally “safer” investments than high yield bonds. More risk, in the case of bonds, refers to the increased probability of default. Given this perspective, a few key differences exit between the two:
Investors will demand a higher expected return high yields to make up for the additional risk of the investments. Please refer to our latest market update to see the yield differentials for each credit rating.
High yield instruments will generally have more restrictive financial covenants set by lenders. Breach of the covenants could lead to an increase in the interest rate, triggering of additional fees, or even be considered an event of default (in which case the lenders may choose to take control of the assets to either replace the management team or sell the assets in order to recoup their principal).
Given the greater yield on high yield instruments, these bonds will experience greater volatility and sensitivity to movements in interest rate changes. From the lesson on the relationship between bond prices and yields (namely, they are inversely related), the magnitude of the impact of changing yields will be greater for riskier investments. This is measured by ‘duration’ and ‘convexity’ (we will discuss these in later posts).
The maturities of investment grade bonds are typically longer given the relative trustworthiness of the company.
There are generally two ways to incorporate credit ratings of bonds into risk management strategies.
First, for a portfolio of bonds, each individual bond will typically have an individual credit rating. Based on a weighted average approach, an investor can view the overall risk of the portfolio by calculating an assumed “portfolio credit rating.” There are two steps in this process.
Assign an ordinal indicator to each credit rating category. For example, in the case of S&P credit ratings, we have assigned a figure to each credit rating category:
Next, we can find the assumed numerical weighting based on the credit rating of each bond. In the chart below, we have inserted random credit ratings to the dollar amount of each individual bond. Based on the weighted average of each portfolio position (dividing each holding amount by the total dollar amount held) and the numerical rating of each position, we can estimate the weighted average contribution in the “Weighted Avg Rating” column. After summing all of these rating contributions, we calculate a numerical rating of 3.8 for the portfolio. Looking back above at point 1, this implies a credit rating in between A and BBB.
The second way to incorporate credit ratings into risk management is by observing changes over time. Over time, as credit ratings increase or decrease, the investor can make adjustments to fine tune the portfolio. For example, in the case above, if the investor wants to keep a rating of A as the minimum for the portfolio, they may consider selling lower rated bonds (such as Bond 6, Bond 3, or Bond 4) and purchasing other bonds with higher credit ratings.
Total Return Perspective
One key element of utilizing credit ratings is to find potential cases where an investor believes a bond will receive a credit upgrade in the future. For example, a bond may be upgraded from a BBB to an A. Ratings upgrades occur when recent performance, the macroeconomic backdrop, or some other factor occurs and the credit rating agency determines it has materially lessened the company’s probability of default. For example, see the link here for a recent Moody’s upgrade of Anglo American.
When this occurs, investors are willing to acquire the bond at a greater price given the risk reduction in the position. The key to this strategy is to predict when and if a company will experience a ratings upgrade. If an investor is successful with this strategy, they are able to lock in a higher return by selling the bond at a higher price than they acquired it for.
Credit ratings are an important component of risk management and bond investment strategy. Investors must be aware of various strategies they can deploy to take advantage of changes in the company’s rating. For example, a recent rating downgrade may provide an investor to take advantage of a lower price. However, the investor must be willing to either take on the additional risk or believe that some change will occur to reverse this trend sometime in the future.