Bruno Iksil and the CHIPS trade

By Felix Salmon
April 17, 2012
John Carney has been plugging away at what on earth Bruno Iskil, the so-called London Whale, might be doing with his reported $100 billion bet on an obscure off-the-run CDX index.

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John Carney has been plugging away at what on earth Bruno Iskil, the so-called London Whale, might be doing with his reported $100 billion bet on an obscure off-the-run CDX index. Carney’s idea is that this is all part of some kind of inflation-protection trade, but as Ben Walsh says, if you want to protect against inflation, you just buy TIPS. Corporate credit default swaps aren’t going to help you out much on that front.

But thinking about it a bit more, Carney’s CHIPS theory (for Corporate Hedging Inflation-Protected Securities) makes a certain amount of sense. Let’s say that Iksil, with his $360 billion portfolio, wants to make money in the fixed-income markets even as he sees inflation appearing over the next 5 years. It’s never easy for bond investors to make money in the face of inflation, since they’re receiving a fixed income, and that fixed income is effectively being eroded by inflation. And with rates as low as they are today, investors aren’t being paid for the inflation risk they’re taking.

Most normal investors are faced with a choice: they can either get insanely low yields on TIPS, and protect themselves from inflation, or else they can get slightly higher yields on corporate bonds, but leave themselves open to having their money eroded by inflation.

Iksil, however, might have found a way of managing to have his cake and eat it. He buys TIPS — say the 10-year series issued in January 2007, which matures in January 2017. Because those TIPS are now off the run, he gets a slightly higher yield on them.

At the same time, Iksil wants exposure to investment-grade corporate credit risk. If you or I had put our money in TIPS, we couldn’t do that, because, well, our money would be tied up in TIPS. But Iksil works for JP Morgan, so he can get credit risk without having to tie up any money at all. All he needs to do is sell protection on a CDX index which matures at roughly the same time — in this case, Series 9 of the Markit CDX North America Investment Grade Index, which matures in September 2017.

Now the great thing about selling protection, rather than buying bonds, is that it costs you nothing up-front. Quite the opposite, in fact: you get paid for doing it. Iksil is cashing insurance premiums on a basket of corporate debt every six months, and he can add that cashflow to the much more modest cashflow he’s getting on his TIPS. And because he’s JP Morgan, even if the market moves against him, he’s unlikely to have to put up much if any margin.

Put the TIPS and the CDX trade together into a package, and you get what Carney calls CHIPS, or what Pimco managing director Mihir Worah cals CIPS: Corporate Inflation-Linked Securities. (Yeah, I know, that looks more like CILS to me.)

What happens now if inflation picks up before 2017? For one thing, Iksil will make money on his TIPS, which go up in value when inflation rises. But Iksil will also make money on his CDX trade. The yield on a corporate bond is basically made up of two elements, called credit and rates. The rates part is the bit which goes up when inflation appears. But when you’re selling credit protection, you’re stripping out the rates part, and you’re exposing yourself only to the credit part of the equation.

And when inflation appears, corporate credit risk actually goes down, not up. Inflation is bad for lenders; it’s good for borrowers. And it means, generally speaking, that companies are raising their prices and bringing in more money, in nominal terms. Which means they have a higher income with which to pay off their fixed debts. Which means that they’re more likely to be able to pay those debts off in full.

Indeed, if you look at the rate sensitivity of the index that Iksil is buying, his mark-to-market P&L goes up when rates go up. For every basis point that rates rise, Iksil makes a profit, if he has $100 billion of exposure, of roughly $650,000. If yields go up by one percentage point, Iksil has made himself $65 million, just on the CDX part of the trade. Which is quite an achievement for a fixed-income investor in a rising-rates environment. Add in the profit on his TIPS, and he’s making even more.

It’s a big and risky trade — but it’s not one which he’s ever necessarily going to have to unwind. It has a maturity of about 5 years, and JP Morgan is more than big enough to hold a 5-year trade to maturity.

But is that really what he’s doing? There’s one very good reason to believe it’s much more complicated than I’ve laid out: if you look at those TIPS maturing in 2017, there were only $9 billion of them issued in total. And more generally, what Iksil is doing here is basically replicating the kind of corporate credit exposure that JP Morgan has lots of already. This isn’t in any way a hedge of JP Morgan’s existing portfolio; it’s more of a doubling-down on it.

Still, looked at one way, Iksil’s job is to take the assets that JP Morgan hasn’t been able to loan out, and get the kind of return on those assets that JP Morgan would be seeing if it had been able to loan them out. So maybe it makes sense that he’s making a big bet on corporate credit. I just wonder where on earth he could possibly find $100 billion of inflation protection.

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