Pimco and the JPMorgan Whale: CHIP-ing Away at a Scandal


Last week, I explained how the position taken in the CDX market by Burno Iskil, the so-called London Whale of JPMorgan’s chief investment office, could be an overlay hedge attempt to raise yields on Treasury Inflation Protected Securities, or TIPS.

The basic idea is that a trader could go long CDX.IG.NA, an index of 10 dozen or so investment-grade US bonds, in an attempt to generate more yield against the negative yields currently for offer from TIPS. This way, the trader could stay protected from inflation without losing money along the way.

We know that JPMorgan is positioning itself to benefit from rising rates. That directional bet is spelled out in its 10-K. Presumably, it wants to protect itself from inflation that could trigger rate hikes. But it wants to keep the cost of that protection cheap enough that it doesn’t lose the benefit of the directional bet on rates. Hence, the TIPS plus CDX overlay.

I got the idea for this trade from a credit trader at a rival bank based in Europe. But it turns out that it was also recommended a year and a half ago by Pimco managing director Mihir Worah.

In a “viewpoint” on Pimco’s website , entitled “TIPS for Inflation Protection Or, How I Learned to Stop Hating Low Yields and Started to Enhance Them,” Mihir spells out the problems created by low yielding TIPS—and various ways of overcoming them.

“There are a number of ways investors can look to take advantage of the inflation-hedging properties of TIPS without locking in current low yields," Mihir wrote.

Some of his TIPS tips are rather straight-forward. Targeting TIPS at parts of the yield curve that still offer fundamental value; concentrating on cheap issues; and selling matched regular Treasurys.

But Mihir also proposes more complicated “overlay strategies,” including one very similar to the strategy my source believes is driving the JPMorgan Whale.

From Mihir:

One approach is to use a derivatives-based overlay to combine the inflation protection of TIPS with the higher return potential from other asset classes. For example, combine a portfolio of TIPS with an overlay of a Credit Default Swap (CDX) index. This strategy combines the inflation-hedging property of TIPS with the higher yield potential of corporate bonds, essentially creating a synthetic portfolio of Corporate Inflation-Linked Securities (CIPS). For illustrative purposes, combining the 5-year Investment Grade CDX, which currently trades at a spread of 0.91%, with 5-year TIPS may result in a portfolio with a real yield of approximately +0.6% compared to ?0.29% for just the TIPS currently. Similarly, combining the 5-year High Yield CDX, which has a spread of 4.80% as of 11/15/2010 with 5-year TIPS results in a synthetic 5-year real rate of approximately 4.5% (4.8% -0.29% = 4.5%).

In other words, the Whale has created a synthetic long position in corporate bonds as an overlay on a long position in TIPS, creating a synthetic Corporate Hedging Inflation-Protected Securities portfolio.

Insert your joke about letting “the CHIPS fall where they may” here.

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