October 10, 2013 11:44 pm

Debt impasse exposes Achilles’ heel of finance

By Gillian Tett

Risk of an accident in $2tn tri-party repo market is rising

Who is getting spooked by Halloween bonds? That is a question which many traders are wondering. Little wonder. A week ago, I (like most people) blithely assumed that Congress would find a way to resolve the budget and debt ceiling impasse before the crucial October 17 deadline, when the Treasury claims it will start running out of funds.

Now I am less sure. For the situation seems to have fallen into a pattern which defies neat, game-theory solutions: the White House does not want to give the Tea Party any victories, for fear of encouraging more hostage-taking; John Boehner, Republican House Speaker, cannot offer concessions for fear of losing his position; and the Tea Party now regards the fight as a “do-or-die” stand and also fears it.

Of course, since this is Washington - where deadline crises are as ingrained in political culture as “alarm clocks”, as the quip goes - I am still assuming that a last minute deal will get done. The latest calls from Mr Boehner for a six-week “extension” for the debt ceiling to late November, moving the deadline to Thanksgiving, certainly fit this mould.

Shameful omission

But the risk of an accident is rising. For the key thing that investors, voters and politicians need to grasp is that this fight is not simply creating concern about Treasury bills that expire in late October (aka “Halloween”), or even six weeks later, undermining the securities’ sanctity. It is also threatening to expose a dangerous Achilles’ heel of finance – and shameful omission in the recent regulatory reform - that has been haunting markets for years.
The issue at stake is the $2tn tri-party repurchasing market where financial institutions raise cash for short-term needs, by pledging securities (such as those T-bills) as collateral.

Before 2008, this repo world was widely ignored since its operations appeared staid and dull. But when entities such as Bear Stearns and Lehman Brothers tipped into crisis, it became clear American tri-party repo is built on shaky foundations. There is no lender of last resort and no neutral third-party exchange or clearing platform to complete deals swiftly if a party fails, or a security defaults. Instead, clearing is concentrated in the hands of two private-sector players: Bank of New York and JPMorgan. Worse, transactions can be left in a state of limbo during the trading day.

Thus if a jolt hits the system, this can potentially spark panic. And that could spread contagion since the system is such a crucial source of funding for every large financial player.

Now, the good news is that the New York Federal Reserve Bank recognises this vulnerability – and has repeatedly demanded reforms in the past five years. Indeed, just last week Fed officials held a conference where it sternly warned of “fire sale” risks in the repo world – and demanded change. But the bad news is that reform has been shamefully slow and timid, partly because the NYFRB has tried to work in a collaborative manner with the banks, rather than simply using its supervisory powers to force change.

As a result, there is still no watertight framework in place to cope with a scenario where a large party fails, or a panic erupts around certain securities, and sparks fire sales. And while intraday trading balances are being handled better, the risks are not completely resolved. Or as the International Monetary Fund said in its Global Financial Stability Review this week: “Some progress has been made in reducing financial stability risks surrounding repo markets... [however] short term secured funding markets are still exposed to potential runs.”

Repo freeze

If a technical default occurs on those T-bills, in other words, this could freeze parts of the system. Indeed, profound problems could occur even if the Treasury devises clever conjuring tricks to keep paying interest on its bonds after October 17, since these would inevitably be subject to subsequent legal challenge – and foster stigma and uncertainty.

But here is the real rub: though this Achilles’ heel spooks market cognoscenti, most Tea Party supporters have no idea the repo world even exists. Voters know what a crashing stock market looks like; tri-party repo deals are a mystery. And while some senior government officials are trying to find ways to communicate the message - say by likening repo to a giant pawn-shop-cum-plumbing system – this “messaging” challenge is huge.

Hence the risk of an “accident” taking place, if the battle goes to the wire; and hence the growing sense of unease among market insiders. Indeed, the only piece of good news in this sorry tale is that when the dust settles on the debacle – be that with a six-week extension or anything else – this could prod regulators and banks get more serious about repo market reform. It is just a pity that more radical reform did not occur five years ago; if so, this Halloween mess would not look so scary.

October 7, 2013 3:49 pm

America cannot live so carelessly forever

By Gideon Rachman

Playing Russian roulette is never advisable. Congress may find a bullet in the chamber this time

Watching the US budget crisis unfold, I was reminded of a famous passage in The Great Gatsby. “They were careless people, Tom and Daisy,” wrote F Scott Fitzgerald, “they smashed up things, and creatures and then retreated back into their money or their vast carelessness or whatever it was that kept them together.”

Right now, the Republicans and Democrats in Washington are behaving like the Tom and Daisy of global politics – a warring couple, whose rows seem more likely to damage innocent bystanders than themselves. American politicians seem confident that their nation’s wealth and power allow them to get away with careless behaviour that would be swiftly punished in a weaker and poorer country.

History suggests that this complacency is justified. Congress has played Russian roulette with government shutdowns before – and the bullet chamber has always been empty. More broadly, the 50 years since the assassination of John F. Kennedy have thrown up repeated political melodramas – from Watergate to the impeachment of President Bill Clinton. Each time, many thought that the American system was unravelling. Yet, each time, the US bounced back. For while America’s political flaws are very visible, its economic and social strengths are too easily discounted.

By contrast, foreigners have sometimes paid a heavy price for careless behaviour in Washington. It is a standard, self-pitying complaint in Brussels that the crisis in the eurozone was triggered by the collapse of a US investment bank, Lehman Brothers. A large part of the rest of the world’s grim fascination with the budget crisis reflects the fear that if the US economy catches another cold, the rest of the world will get pneumonia. China has told the US not to imperil the value of its holdings of US Treasury bills and Christine Lagarde, head of the International Monetary Fund, has warned of the damage the crisis could do to the world economy. But such complaints are drowned out by self-interested bickering in Congress.

The sense that the US is prone to “careless” behaviour that puts others at risk extends to international politics. America paid a high price in lives lost and money wasted during the Iraq war. But the US has now gone home and lost interest. Iraq, meanwhile, is still in the grip of the terrible civil conflict that followed the overthrow of Saddam Hussein.

The current crisis evokes mixed reactions in foreigners. Many, like Ms Lagarde, know that the rest of the world could pay a heavy price for the folly in Washington – and genuinely long for the Americans to pull themselves together.

America’s admirers wince at the sight of a nation that they hold up as a model, making itself look so bad. But among those that resent US global leadership, there is considerable schadenfreude at the sense that the Americans – who like to preach about democracy abroad – are making such a bad fist of democracy at home. The Chinese will also be delighted that America’s efforts to assert leadership in Asia at the Apec summit have been thwarted by the fact that President Barack Obama has had to pull out to attend to the crisis in Washington. As for Vladimir Putin, Russia’s president – who recently took to the pages of The New York Times to warn Americans against the dangers of believing themselves “exceptional” – he would doubtless take a certain pleasure, if the markets eventually told Americans that they were not so exceptional, after all.

Conversely, the fear for the likes of Mr Putin is that those careless Americans will get another free pass. For the fact is that the US is so important to the smooth functioning of the global economy that the rest of the world has a vested interest in overlooking reckless behaviour in Washington. The last time the US played fast and loose with the debt ceiling, in 2011, Standard & Poor’s downgraded its debt rating. At the time many commentators saw this as a historic turning point and predicted that America’s borrowing costs would soar. In reality borrowing costs stayed low. Tom and Daisy had got away with it, again.

However, the fact that America has repeatedly survived careless behaviour – and bounced back from crises – has bolstered the inward-looking complacency in Washington. That, in turn, seems to have persuaded US politicians that they can take ever greater risks with the nation’s finances. But repeated games of Russian roulette are never advisable. It is certainly possible that this time Congress will spin the chamber – and find that there really is a bullet in it.

If a compromise is reached before the US Treasury runs up against the debt ceiling on October 17, then this will probably just be a case of “crisis as usual”. But if America crashes through the debt barrier, things get serious. As Gavyn Davies argued last week, it seems marginally more likely that the Obama administration will drastically cut back on current expenditure rather than default on debt payments. Moving overnight to a balanced budget would be a form of immediate forced austerity of the kind that has caused deep recessions in countries such as Greece and Spain – as they too have struggled to balance their budgets.

The difference would be that US austerity would be caused not by the pressure of the markets, or the IMF – instead it would be a self-inflicted wound that caused huge damage to ordinary Americans and to the global economy. That really would be careless.

The Perils of Mopping Up

October 11, 2013 

by Doug Noland

Six days and counting.  The markets have already discounted a deal. October 9 – Reuters (David Milliken): “The U.S. Federal Reserve should try to stop a damaging cycle of booms and busts by breaking investors’ expectations that it will mop up after future asset price bubbles, one of the pioneers of inflation-targeting said. Arthur Grimes, who developed inflation-targeting at the Reserve Bank of New Zealand in the late 1980s, said the Fed had inadvertently made bubbles more likely by promising to help the economy after they burst. ‘The largest economy in the world is leading policies that lead to asset booms. It makes it incredibly difficult for other central banks to have a credible policy.’… Grimes said investors were still likely to pile into asset price bubbles because they expected that even if they burst, central bank action to support the economy would soon cause asset prices to return to their previous levels. The U.S. Federal Reserve was particularly at fault after repeatedly supporting markets following brief episodes of financial market turmoil from the 1980s onwards, Grimes said. ‘In my view it was a big mistake by the Federal Reserve… They are stuck between a rock and a hard place, in terms of the Fed officials themselves. You would have to have a big bang to say: ‘We are targeting price stability. We are targeting stable asset prices as well as stable goods prices.’ … Grimes also had words of caution for central banks adopting forward guidance on their future interest rates, saying it needed to be consistent and should not be a mask for changing inflation goals. ‘If you revise based on new information, that is fine. If (the public) think you are going to revise your criteria for where you are going, then you lose your credibility,’ he said.”
President Obama lavished praise on the soon-retiring Ben Bernanke this week as he announced Janet Yellen as his choice to head the Federal Reserve. Market players absolutely love Bernanke and were cheered by the Yellen selection. Larry Summers? Well, he certainly wasn’t wedded to the QE experiment and would have likely taken a less than friendly view of the Fed backstopping markets and targeting higher asset prices.
I was critical of the decision to appoint Dr. Bernanke Fed chairman back in 2004. From my (and others’) perspective, it’s difficult to Credit him for rescuing the system from near collapse back in 2008/09. After all, his doctrine and policies were fundamental to the preceding Bubble.
During the Greenspan era, the Fed strayed dangerously away from sound central banking. Ben Bernanke, the esteemed academic and expert on the causes of the Great Depression, was the last person that would pull the Federal Reserve back from activism, market manipulation and inflationism. And, indeed, he championed the view that central banks should ignore asset Bubbles and instead rely on regulation to contain excess. Central to Bernanke’s thesis was that Bubbles could be ignored with the understanding that central banks (with their electronic “printing press”) enjoy the capacity for aggressive post-Bubble “mopping up” reflationary measures.
Essentially, the doctrine holds that debt problems can be inflated away through aggressive monetary expansion. The Federal Reserve targeted mortgage Credit as the reflationary expedient in the post-tech Bubble reflation – with disastrous consequences. Somehow, the Fed and its flawed doctrine were never held accountable. What began as the Fed employing federal government Credit as its post-mortgage finance Bubble reflationary expedient has morphed into an experimental use of its own Credit to directly inflate asset markets.
As conventional thinking has it, “Thank God for the Bernanke Fed with all the dysfunction from Washington politicians.” Yet our central bank should take primary responsibility. After all, Washington and the country are divided by the issues of massive deficits and the government’s commanding role throughout the U.S. economy. This is a direct consequence of previous serial Bubbles and the Fed’s expansive “Mopping Up” operations. It is also a reminder of how history warns that once monetary inflation takes hold it garners many supporting constituencies.
The Fed has immersed itself in the middle of deeply-divided politics. Federal Reserve policies have fomented speculative asset Bubbles and attendant wealth redistribution. Those on the political left have justification for distrusting the markets, while pressing forward with policies of redistribution. Fed-induced monetary instability has led to severe structural maladjustment. Fed “mopping up” has monetized an unprecedented peacetime expansion of public spending and deficits. There is ample support for the view that fiscal and monetary policies have been deeply detrimental to the economy and society. Those on the political right have justification for their view that “money printing” and “big government” risk the downfall of our great nation.
I was struck by comments from Wall Street punditry in the aftermath of the Yellen announcement. “She will touch people in a more feminine way.” “Good for our democracy.” General market sentiment was captured by Ambrose-Evans Pritchard’s headline in the Guardian: “Rejoice: The Yellen Fed Will Print Money Forever to Create Jobs.”
For starters, the Fed and our country are in desperate need of a strong and independent leader that would be willing to administer tough love and begin the punchbowl removal process. Unfortunately, the markets today enjoy veto power and would in no way tolerate a Paul Volcker type. The Street prefers someone that is willing to advance this experiment in unprecedented monetary inflation. It was no coincidence that Bernanke was even more experimental than Greenspan and that Yellen is seen as even more the “uber-dove” than “Helicopter Ben.” It is no coincidence that academics dominate today’s Federal Reserve.
Dr. Yellen good for democracy? This is actually a critical issue. So, why don’t we just have voters elect the Federal Reserve chairman? Better yet, we could instead just let Congress or the President dictate monetary policy. How about we allow them to work together and come to a consensus on rates and a weekly QE quantity?
Monetary stability – stable “money” and Credit – are good for democracy. History is unequivocal, unsound finance and resulting booms and busts are bad for society, social stability and democracy. An independent central bank some distance from political influence is fundamental to monetary stability. And, I would argue, it is impossible to have monetary stability in an environment where central bankers are aggressively intervening in the markets, printing money and targeting higher asset prices. I believe Arthur Grimes (see comments above), for years Chairman of the respected Reserve Bank of New Zealand, would agree.
During a CNBC interview, Harvard history professor Niall Ferguson spoke of “desperate improvisation” at the Federal Reserve. Ferguson also stated an interesting view of how Yellen might differ from Bernanke: “Theoretically [she is] on the same page as Bernanke, but covertly, she would really like to have a nominal GDP target—a new level of policy innovation on the monetary side.”
An inflation target; an unemployment rate target; a target for the short-term “Fed funds” rate; a target for market bond yields; and now, perhaps, a GDP target. Lots of policy targets that obfuscate the Fed’s true intentions: The Fed is trapped in a desperate monetary inflation and there is apparently no mechanism to rein in our central bank.
The Fed’s unstated goal is to inflate Credit sufficiently to grow beyond previous debt problems and associated financial and economic fragilities. I have noted that annual non-financial Credit growth was about $650bn in the mid-nineties. A historic Credit boom saw annual non-financial growth surge to a peak level $2.55 TN in 2007.
It is central to my Macro Credit Thesis that protracted Credit booms raise various price levels throughout the financial and economic systems. Moreover, Credit excesses distort spending and investing patterns in the real economy, leading to progressively problematic structural maladjustment. Importantly, increasingly inflated asset prices and economic maladjustment foster systemic dependency to large and ever-expanding Credit expansion.
After the bursting of the mortgage finance Bubble, I posited that it would require in the neighborhood of $2 TN annual Credit growth to reflate the structurally maladjusted U.S. economy. Furthermore, I stated this posed a major ongoing dilemma for the Federal Reserve. Massive deficit spending and Federal Reserve monetization were sufficient to initially stabilize asset markets and the economy. At the end of the day, however, it would remain a significant continuing challenge to achieve the requisite $2 TN annual Credit growth bogey. I believed the Household sector would have little appetite for adding to its huge debt load, while the Corporate sector was already sitting on (mortgage finance Bubble-enhanced) large cash balances. And I did not believe the $1.5 TN annual federal deficits from 2009 and 2010 – instrumental in reflating incomes, spending and corporate earnings - were sustainable.
Many speak of the need for the economy to reach “escape velocity.” From my analytical perspective, this in a similar vein as my required $2.0 TN or so of annual Credit growth that would fuel asset inflation and sufficient spending to power a self-reinforcing expansion in our services/consumption dominated economy. With mortgage Credit and Household debt still contracting, it became increasingly clear to Fed policymakers in 2012 that the Credit-dependent recovery was at heightened vulnerability.  “Mopping Up” wasn’t working as the theory and econometric models had forecast. The Fed decided to take a major gamble with aggressive non-crisis QE.
Non-crisis QE should be thought of as a mechanism to short circuit normal (financial and economic) system operations – and a particularly dangerous one at that. Instead of Credit expansion and more typical economic processes feeding into higher investment, incomes, corporate earnings and wealth creation, the Fed moved to bypass the economy and inject unprecedented liquidity directly to spur risk-taking and inflated securities markets.
I wrote last week that injecting liquidity into already overheated speculative markets is tantamount to QE as rocket fuel. It both inflates securities prices directly while it also heavily incentivizes risk-taking and speculative leveraging. Couple rocket fuel QE with “transparency,” “forward guidance,” and a promise to backstop markets in the event of a “tightening of financial conditions,” and you’ve progressed all the way to reckless monetary policy. Is the Fed really promising the markets that they will remain ultra-accommodative for at least the next couple years in the face of conspicuously speculative securities markets and increasingly overheated asset markets generally?
The Janet Yellen confirmation hearings could be an interesting affair. To what extent could it become a more general hearing on Federal Reserve doctrine and policy? Over the years I’ve highlighted the central bank “Rules vs. Discretion” debate that’s been around for generations.
Our great nation’s brilliant Founding Fathers clearly appreciated the perils of unsound money. They understood the dangers of excessive power and the necessity for checks and balances. They would have never anticipated an American central bank printing money without restraint. There was a major flaw in the structure of the Federal Reserve System – and for central bank structures generally. I just don’t think anyone ever anticipated that central bankers might someday resort to creating Trillions of “money” as they do today – on a whim or academic theory. The Federal Reserve needs some basic concrete rules. It’s insanity to allow a small group of unelected officials the discretion to pump $85bn – or more! - of purchasing power into the markets every month. It’s undemocratic, highly risky and this has gone on for much too long. If there was one issue worth closing down the government and risking default, this would be it.


The Risk Beyond the Beltway

The speculative surge in names like Priceline and Netflix brings back memories of past periods of excess.

They may be dumb in D.C., but they're not stupid. Congress and the White House have long been used to the contempt of the electorate; if we keep sending our representatives back, why should they care? Ditto the swoons of the stock market; the Dow may drop 100-plus points a day -- day after day -- but they're still there.
Even the threat of default on the debt of the United States of America wasn't taken too seriously, either on Capitol Hill or most of Wall Street. Of the former, a reincarnation of the Know Nothing Party of the 19th century asserted that default wouldn't really matter. By its line of reasoning, our creditors would get paid, maybe a few days late, but so what? Meanwhile, back in Manhattan, the assumption was that a default was too awful to contemplate, so its chances were deemed negligible.
Only when some big investors actually began to eschew some of Uncle Sam's IOUs that might not get paid off precisely on time did the standoff between House Republicans and the Obama administration begin to show signs of breaking up. Negative poll numbers and a shaky stock market -- those things shall pass. But when the biggest names in money markets are dumping T-bills that conceivably could be caught in a post-Oct. 17 debt apocalypse, that's serious. Big spenders know better than anybody the consequences when their credit lines run out.
To be sure, the Oct. 17 drop-dead date set by Treasury Secretary Jack Lew isn't as fatal as he asserted. Bank of America Merrill Lynch estimates the Treasury could squeak through to Oct. 31 to pay interest and principal due up until that date. Nov. 1 is the real drop-dead date, when big Social Security, defense, veterans' and Medicare payments come due. After that, Merrill says it's unlikely the Treasury would be able to meet its obligations.
The House GOP's plans to extend the debt limit for six weeks merely kicks the can into November-December, but that was enough to spark a big, 2% rally in the major stock averages on Thursday. That was the best showing since Jan. 2, when equities roared ahead after Washington avoided taking a header over the fiscal cliff (remember that scare?). Leading Thursday's surge were the go-go Internet favorites of 2013, which had gotten whacked hard in the selloff of the first three days of the week as traders saw a chance to cash in their winnings before they gave them back because of the dysfunction in D.C.
The speculation in these so-called high-beta names brought back memories of previous eras of excess. Speaking at The Big Picture conference in New York, market veteran Art Cashin alluded to the dot-com era, when the market capitalization of an airline-ticket seller exceeded that of all the airlines. On that score, Fred Hickey, who enlivens the Barron's Roundtable, recalls in the current edition of his High Tech Strategist howPriceline shares (ticker: PCLN) this year returned to the $1,000 reached back in April 1999 -- and how they had plunged to $6.60 by October 2002.
Similarly, Fred notes, Tesla (TSLA) has a market valuation nearly half that of General Motors (GM), even though its revenue of $2 billion pales beside GM's $155 billion. Netflix's (NFLX) stock is over $300, where it was in July 2011, before plunging to $63 five months later. Netflix has to outbid other providers for content, Fred notes, and it's not the only way to get video. He ticks off other momentum plays, includingLinkedIn (LNKD), which took the opportunity to sell high in a recent $1.2 billion stock offering. Finally, NetSuite (N) recalls how we're partying like it's 1999: The shares trade at over 400 times estimated earnings and 23 times sales.
"Just as in 2000 and again in 2007, I could fill a whole newsletter with these nonsensically priced story stocks. But by now, you should get the point. The valuations are out of control," he concludes. And that's likely still to be the case when, eventually, they get their act together in Washington.
AMID THE FISCAL FOLLIES of last week, the financial markets took little heed of Franklin D. Roosevelt's exhortation that "the only thing we have to fear is fear itself," as they fretted over the minute risk of a Treasury default. For markets, fear isn't some indefinable sense of anxiety, but something captured in a single number known as the VIX, the ticker symbol for the CBOE Volatility index, by which the so-called fear gauge is familiarly known.
Despite all of the worries about the debt ceiling, Fed tapering, subpar growth, Syria, and the denouement of Breaking Bad, the VIX has remained in the teens throughout most of the year, a reading connoting confidence or complacency, take your pick. Only when the prospect of a default by the U.S. Treasury entered the realm of "tail risk" (that is, at the thin ends of the "bell curve" of a graph of possibilities) did the VIX briefly climb higher than 20 on Tuesday. That was still well below the high-anxiety readings in the 30s and 40s reached in the summer of 2011, the last time our esteemed leaders played a game of chicken with the credit of the U.S. And with the fear of default receding by week's end, the VIX was back down in the 15-and-change range.
What has emerged has been a bear market in fear. That would seem to be the reasonable result of the Xanax provided by the Federal Reserve in what has been popularly called the Bernanke Put, which is the successor to the Greenspan Put. That's the widely held perception that the monetary authorities will always provide a safety net to the markets in the event of a plunge.
A put option provides the buyer with the right to sell something at a predetermined price; in other words, it's an insurance policy. And, as with insurance, the put buyer pays a premium for that protection, commensurate with the risk. In the case of the Fed, this put protection is being provided free of charge. The monetary authorities' idea is to encourage risk-taking in order to spur economic growth and employment.
The reality is that the perception of reduced risk has fed into the financial markets more than the real economy has. Investors have less incentive to pay up for protection in the options market, which keeps a cap on implied volatilities. As a result, the VIX remains subdued. And the putative wall of worry for the bulls to climb is actually no more than waist-high.
There is another effect the Fed is exerting on the fear gauge. Investors starved for income are resorting to the options market to obtain what they can't get from bonds or stocks.
"Investors are not really buying volatility for fear anymore," Christopher Cole, a founder of the Artemis Vega fund, tells Grant's Interest Rate Observer. "They are selling it as a form of yield. Investors are looking to volatility short-selling strategies as an alternative yield play. Just like every other yield play in this Fed-driven economy, it has reached levels of overvaluation and compression."
Indeed, the record of funds, either of the open- or closed-end variety, that lean on covered-call writing to plump up returns generally has been less than stellar. Still, options can be a worthwhile tool in the hands of a deft practitioner.
Veteran money-manager Martin Sass, who's no stranger to these pages, has been doing just that with the M.D. Sass Equity Income Plusfund (MDEPX). The offering is brand new, and has just $44 million in assets, but the firm has been managing private accounts with the same strategy since July 2009. While that is too short a span to prove the efficacy of his approach, Marty confides that all of his and his wife's Roth IRAs are invested in the fund.
Marty has built his estimable record as an equity guy and contends that stocks are in relatively early innings of a secular advance. Bonds, meanwhile, are in the beginning stages of a long-term rise in yields and decline in prices, so it's obvious where his sentiments lie. At the same time, many investors need current income and don't want the risk of falling bond prices -- which was demonstrated dramatically over the summer when the 10-year Treasury note yield nearly doubled, to 3% from 1.63%, before receding to 2.69% on Friday.
Sass' tack is to invest in a relatively concentrated portfolio of stocks with attractive yields and fundamentals. Then he sells out-of-the-money calls against the stocks to generate income and also buys index puts to protect the portfolio against the downside. Because options premiums on individual stocks generally are higher than on index options, the options strategy generates positive income. In sum, the options cap the upside but put a floor on the downside, just as a bond portfolio would, but with less risk from rising interest rates.
Early returns show that Sass' equity-income strategy has generated 11.23% annual returns from June 1, 2009, through Sept. 30, 2013, compared with 9.53% from the CBOE S&P 500 BuyWrite index, according to data provided by the firm. The strategy also had significantly less volatility in returns than either the BuyWrite index or the Standard & Poor's 500.
It's too early to prove the viability of the Sass strategy. But that it takes such exertions -- a concentrated equity portfolio, plus covered call writing and put protection -- to produce the returns once provided by bonds is a reflection of the cost of low interest rates.