You're Short Volatility (And Don't Know It) | Nancy Davis on the Bond Risk Investors Haven’t Hedged

Key Concepts

Option Selling vs. Option Buying: The prevalent market strategy of selling options (shorting volatility) versus the Quadratic Capital approach of buying options (long optionality).
Interest Rate Volatility: The core focus of Quadratic's ETFs, distinct from equity volatility (VIX).
Convexity: A measure of a bond's sensitivity to interest rate changes, with negative convexity (found in mortgages) meaning losses accelerate as rates change unfavorably. In options, this is related to gamma.
Prepayment Risk: The embedded option in mortgages that allows homeowners to prepay, creating a short option position for mortgage holders.
Passive Investing and Indexing: The rise of passive strategies has led to increased allocation to mortgages in bond portfolios, thus increasing embedded short volatility.
Inflation Hedging: Traditional methods (gold, commodities, real estate, TIPS) versus Quadratic's approach using inflation markets and options.
Consumer Price Index (CPI): The primary index for inflation-protected bonds, but questioned by the speaker due to its methodology and the Fed's own stated reliance on other metrics.
Yield Curve: Used as an indicator of inflation expectations, with a steepening yield curve (uninversion) signaling potential inflation.
Backwardated Volatility Curve: A market condition where longer-dated options are cheaper than shorter-dated ones, indicating a unique opportunity.
BNDD (Quadratic Deflation ETF): Focuses on long-dated nominal Treasuries for investors expecting no Fed rate cuts or falling yields.
IVOL (Quadratic Interest Rate Volatility and Inflation Hedged ETF): Aims to provide long interest rate volatility and inflation protection.

Investment Process and Strategies

The Case for Long Optionality

The prevailing market sentiment is characterized by widespread option selling. This is driven by two primary motivations: hedging, where the goal is for hedges to expire worthless, and speculative writing, where the objective is for options to expire worthless. Quadratic Capital Management, however, advocates for a contrarian approach: using options as a core part of the portfolio, specifically by being long optionality.

The speaker, Nancy, draws from her experience at Goldman Sachs, where the focus was on capital preservation and understanding potential losses. Buying an option is likened to using a debit card, where the maximum loss is limited to the premium paid. This provides a defined downside and the potential for positive convexity (asymmetric payoff) if the underlying thesis plays out. This approach was fundamental to her work on the proprietary trading desk and her subsequent role as head of credit, derivatives, and rate trading.

Understanding Convexity and Prepayment Risk

Convexity is a technical term originating from the bond market, measuring a bond's sensitivity to interest rate changes. While duration is commonly discussed, the speaker emphasizes the importance of convexity, particularly in fixed-income instruments with embedded optionality.

Mortgages are highlighted as a prime example of a negatively convex instrument due to prepayment risk. This risk arises because homeowners have the option to prepay their mortgages when interest rates fall. For the debt owner (e.g., a bondholder), this means they are short an option to the homeowner who is long the option. Being short options inherently leads to a negatively convex profile.

In the options market, convexity is analogous to gamma, which measures how quickly an option's delta (sensitivity to the underlying asset's price) changes. An at-the-money option might have a 50 delta, but gamma describes how rapidly that delta shifts as the underlying price moves.

Quadratic's ETFs: IVOL and BNDD

Quadratic Capital Management's investment process centers on identifying mispriced convexity opportunities, primarily within interest rate volatility. This is reflected in their two fixed-income ETFs:

IVOL (Quadratic Interest Rate Volatility and Inflation Hedged ETF): This ETF is designed to be long interest rate volatility and aims to provide inflation hedging. The rationale is that many investors are unknowingly short volatility through their bond holdings, particularly due to the prevalence of mortgages in major bond indices.
BNDD (Quadratic Deflation ETF): This ETF focuses on long-dated nominal Treasuries. It's positioned for investors who believe the Federal Reserve will not cut rates or that 30-year yields will decline, leading to higher bond prices. It's described as a "turbocharged" version of long-duration Treasuries.

Key Arguments and Perspectives

The Pervasive Short Volatility Exposure

A central argument is that a significant portion of investors are naturally short volatility across various asset classes, often without realizing it. This is attributed to:

Passive Investing and Index Construction: The Bloomberg US Aggregate Bond Index (formerly Lehman Aggregate, then Barclays Aggregate), a benchmark for core fixed income, has a substantial allocation (around 27%) to US mortgages. This means investors holding this index are implicitly short the optionality embedded in mortgages.
Everyday Life: The speaker suggests that many everyday activities and financial decisions can be viewed as short volatility bets.
Correlation: Holding both stocks and corporate bonds from the same company can lead to a similar underlying beta exposure, reinforcing a short volatility stance.

The Inflation Hedging Debate

The speaker presents a critical perspective on conventional inflation hedging strategies:

Limitations of CPI: The reliance on the Consumer Price Index (CPI) for inflation-protected bonds (TIPS) and other inflation metrics is questioned. The speaker points out that the Fed itself does not solely rely on CPI and that a significant portion of CPI is owner-occupied rent (shelter), which may not reflect true inflation for all.
Historical Parallels (1970s): The speaker cautions against drawing direct parallels to the 1970s inflation environment, arguing that the financial markets and instruments available then were vastly different. Inflation markets, interest rate derivatives, and TIPS did not exist in their current form.
Gold as an Inflation Hedge: While acknowledging gold's recent performance and its role as a psychological or currency debasement hedge, the speaker argues it's not a consistent inflation hedge because it doesn't pay a coupon. In a high-interest-rate environment, the opportunity cost of holding gold can be significant.
Commodities (Oil, Agriculture): These are also presented as potentially unreliable inflation hedges due to technological advancements (e.g., fertilizers, hydroponics for agriculture; fracking, solar for oil) that can drive prices down.
TIPS Limitations: While TIPS are inflation-protected, they are inherently long-duration and rely on CPI. Quadratic's IVOL ETF aims to "fix" these issues by incorporating options.

The Yield Curve as an Inflation Indicator

The yield curve is presented as a crucial, albeit underutilized, indicator of inflation expectations. The speaker emphasizes that the rest of the world lends money in dollars based on the yield curve, not just the Fed's policy rate.

Current State: The yield curve is described as very flat, with the 2s10s SOFR spot curve at 28 basis points. This is considered historically cheap, especially coming out of a period of significant yield curve inversion.
Historical Uninversion: Research indicates that after yield curves uninvert, they can historically steepen significantly, reaching up to 300 basis points. The current 28 basis points is far below the historical average of around 100 basis points.
Opportunity: This steepening potential is seen as an attractive opportunity, particularly for the IVOL ETF, which aims to express a steeper yield curve.

Interest Rate Volatility: A Compelling Opportunity

Interest rate volatility is identified as a particularly attractive asset class due to its historically low levels.

Post-SVB Decline: Despite the issues that led to the Silicon Valley Bank collapse, interest rate volatility has fallen significantly (around 40%) since then, with no fundamental changes in the underlying risks.
Low Implied Volatility: The price of convexity (the asymmetric payoff) is very low, meaning investors can buy more options for the same premium.
Backwardated Volatility Curve: The volatility curve for the type of options accessed by IVOL is backwardated, meaning longer-dated options are cheaper than shorter-dated ones. This is unusual, as the future is typically more uncertain than the present.

The Orphan Asset Class of Inflation Protection in the US

A significant point is made about the lack of readily available and integrated inflation protection in the US market.

Absence in Indices: The core US bond indices do not include inflation-protected bonds, creating tracking risk for investors seeking such protection.
Mandatory Inclusion Elsewhere: In countries like the UK, pension funds are mandated to hold inflation-protected bonds ("linkers").
Underutilization of TIPS: TIPS are widely underused in US portfolios, partly because they are not in core indices and partly because they are naturally long-duration and rely on CPI.

Step-by-Step Processes and Methodologies

Identifying Mispriced Convexity

Quadratic Capital Management's framework for identifying mispriced convexity opportunities involves:

Focus on Interest Rate Volatility: This is the primary area of focus for their ETFs.
Analyzing Embedded Optionality: Identifying instruments where investors are implicitly short options (e.g., mortgages, structured credit).
Evaluating Volatility Levels: Assessing the current price of implied volatility in interest rate markets.
Examining Yield Curve Dynamics: Using the yield curve as a proxy for inflation expectations and identifying opportunities in its steepening.
Leveraging Options Strategies: Constructing portfolios with positively convex options coupled with Treasuries to gain exposure to these mispricings.

Constructing the IVOL ETF

The IVOL ETF is built to address the perceived shortcomings in traditional inflation hedging and fixed-income portfolios:

Long Interest Rate Volatility: The core strategy is to be long interest rate volatility.
Inflation Hedging Component: Incorporates strategies to hedge against inflation, moving beyond just CPI-linked instruments.
Positive Convexity: Uses options to create a positively convex payoff profile.
Treasury and Cash Holdings: Approximately 80% of the fund is invested in Treasuries or cash, providing a stable base.
Addressing TIPS Limitations: Aims to improve upon TIPS by using options to manage duration risk and potentially profit from rising inflation expectations.

Constructing the BNDD ETF

The BNDD ETF is designed for a specific macro view:

Long-Dated Nominal Treasuries: Utilizes very long-dated nominal Treasury bonds.
Macro View: Targeted at investors who believe the Fed will not cut rates or that 30-year yields will fall (bond prices rise).
"Turbocharged" Duration: Offers amplified exposure to long-duration Treasuries.

Data, Research Findings, and Statistics

Mortgage Allocation in AGG Index: Approximately 27% of the Bloomberg US Aggregate Bond Index is allocated to US mortgages.
Yield Curve Steepening Potential: Historical research suggests that after uninversion, the 2s10s yield curve can rise as high as 300 basis points. Currently, it is at 28 basis points.
Historical Yield Curve Average: On average, the 2s10s swaps curve is around 100 basis points.
Interest Rate Volatility Decline: Interest rate volatility has decreased by approximately 40% since the Silicon Valley Bank collapse in 2023.
IVOL Performance (Q1 2021): IVOL was up 311 basis points, while TIPS (with 85% allocation) were down about 150 basis points during the first quarter of 2021.
Break-Even Rates: The 5-year break-even rate is 2.32%, and the 10-year break-even rate is 2.27%, suggesting markets are priced for around 2% long-term inflation.
1-2 Year Break-Even in 2008: The 1-2 year break-even rate went down to -6% in 2008, demonstrating the potential for negative inflation expectations.

Notable Quotes and Significant Statements

"The whole world right now is selling options, right? They're they're either hedging and they want the hedges to expire worthless... or they're writing options, selling options, and they just want them to expire." - Nancy, highlighting the market's prevailing strategy.
"We think a really unique alpha is actually using the options as part of the portfolio." - Nancy, articulating Quadratic's contrarian approach.
"When you buy an option you can never lose more than the premium that you spend." - Nancy, explaining the risk management aspect of buying options.
"Mortgages are you know have negative convexity and any type of fixed income instrument that has embedded short optionality like they call it prepayment risk." - Nancy, defining negative convexity in mortgages.
"When you're short options, you're short volatility. And it's not it's not the VIX. It's not equity ball. It's actually interest rate ball which is embedded in mortgages." - Nancy, clarifying the type of volatility being discussed.
"I personally think everyone should own the Eyeball ETF. You know, that's a broad statement that's pretty bold." - Nancy, expressing strong conviction in the IVOL ETF.
"The US Treasury only started issuing inflation protected bonds in the late 90s, right? In the late 90s is when the inflation protected bond market started." - Nancy, highlighting the relative newness of the TIPS market.
"The yield curve right now is very very flat. We own you know there's a lot of different yield curves... the twos 10 sofur spot curve is 28 basis points." - Nancy, providing data on the current yield curve.
"Interest rate volatility... That is to me is like a backup the truck really really attractive, you know, very very low historical levels." - Nancy, emphasizing the attractive valuation of interest rate volatility.
"Most people are always focused on equity ball. And I want to grab people and be like that doesn't really it's not you're not naturally short equity ball but you're naturally short fixed income ball because of the allocations to mortgages and prepayment risk." - Nancy, contrasting equity and fixed-income volatility exposure.
"Selling selling options is not income. It's selling options. It's not SEC yield. It's not income in my opinion." - Nancy, a key takeaway for investors.
"When you buy an option you can lose it all like I'm not saying you can't lose money but you can only lose what you spend right? It's kind of like a debit card when you sell an option you collect a little bit and you can lose a lot more." - Nancy, reiterating the risk asymmetry between buying and selling options.

Logical Connections Between Sections and Ideas

The summary flows logically by first establishing the prevailing market sentiment (option selling) and then introducing Quadratic's alternative approach (long optionality). This leads into an explanation of the core concepts of convexity and prepayment risk, which are crucial for understanding why the market is often short volatility. The discussion then transitions to the specific products (IVOL and BNDD) designed to capitalize on these mispricings, with a deep dive into the rationale behind IVOL's focus on interest rate volatility and inflation hedging. The arguments against conventional inflation hedging methods and the promotion of the yield curve and interest rate volatility as key indicators and opportunities are presented. Finally, the practical application of these strategies in a portfolio context and key lessons for investors are discussed, reinforcing the central themes.

Clear Section Headings

The summary is structured with clear section headings to delineate different aspects of the discussion, including:

Key Concepts
Investment Process and Strategies
- The Case for Long Optionality
- Understanding Convexity and Prepayment Risk
- Quadratic's ETFs: IVOL and BNDD
Key Arguments and Perspectives
- The Pervasive Short Volatility Exposure
- The Inflation Hedging Debate
- The Yield Curve as an Inflation Indicator
- Interest Rate Volatility: A Compelling Opportunity
- The Orphan Asset Class of Inflation Protection in the US
Step-by-Step Processes and Methodologies
- Identifying Mispriced Convexity
- Constructing the IVOL ETF
- Constructing the BNDD ETF
Data, Research Findings, and Statistics
Notable Quotes and Significant Statements
Logical Connections Between Sections and Ideas
Synthesis/Conclusion

Synthesis/Conclusion

The core takeaway from this discussion is that the dominant market practice of selling options, driven by passive investing trends and a misunderstanding of embedded optionality, has created a pervasive short volatility exposure across many portfolios, particularly in fixed income due to mortgage allocations. Quadratic Capital Management offers a differentiated approach by advocating for long optionality, specifically focusing on interest rate volatility and inflation hedging through their IVOL ETF. They argue that traditional inflation hedges are often flawed and that the current market environment presents unique opportunities in interest rate volatility and yield curve steepening due to historically low valuations. The BNDD ETF provides an alternative for investors with a specific view on interest rates. Ultimately, the message is to be aware of one's embedded risks, particularly short volatility and inflation exposure, and to consider strategies that offer positive convexity and genuine inflation protection, rather than relying on instruments that may not deliver as expected. The speaker strongly advises against viewing option selling as income and emphasizes that all investing involves risk.