CH33 - Bonds

Amidst the towering skyscrapers that defined the city's skyline, the Eldorado Fund's office was situated on the 31st floor of the iconic One New York Plaza building, with the blue East River flowing nearby. The office buzzed with energy, the kind that immediately grabbed your attention the moment you walked in.

As Seok-won entered, dressed in a neat turtleneck and a long coat, he was greeted by the sight of the large market situation board on one wall and the lively activity of a dozen traders moving busily across the trading floor.

"Buy 2,000 shares of Exxon, limit order!"

"Okay, confirm and get back to me."

"What's the current price on USX Corporation?"

"Hold! Hold!"

The air was filled with the constant ringing of phones and the rapid typing of keys, creating a scene reminiscent of a battlefield. The traders were intensely focused on their screens or on their phones, placing orders without a moment's pause. Seeing them in action, Seok-won felt a surge of adrenaline coursing through his veins, his chest heating up with excitement.

"It's impressive," he thought to himself.

What thrilled him most was that this dynamic arena, where traders fought like gladiators in the Colosseum, was his very own fund. The mere thought brought a sense of exhilaration.

"You're here," a voice said.

Turning, Seok-won saw Landon, clad in a gray suit, approaching him with a smile.

"It's very lively here," Seok-won commented, his eyes still fixed on the trading floor.

Landon joined him, standing side by side, as they watched the traders continue their energetic work.

"Yes, it's always bustling, but when you stand here and watch, the heat and dynamism that the traders emit make your blood run hot without you even realizing it," Landon said.

Seok-won nodded slightly, understanding the sentiment.

"Let's head inside," Landon suggested.

Following Landon's lead, Seok-won made his way to his private office. Although it had been vacant for some time, regular maintenance had kept it spotless. Through the large floor-to-ceiling windows, he had a clear view of the East River and the dock below.

After a brief glance around the room, Seok-won casually sat down on the large, comfortable sofa, which seemed to fit him perfectly.

Landon took a seat to his right, just as a slender, black-haired woman in a two-piece suit knocked and entered the room. It was Daisy, the secretary.

"Mr. Andrew is here to see you," Daisy announced.

"Let him in," Seok-won replied.

Daisy stepped aside, and in walked Andrew, wearing dress slacks, a white shirt, and beige suspenders. Seok-won stood up, warmly extending his hand as Andrew approached.

"I hope I didn't pull you away from anything too important," Seok-won greeted him.

"No worries. No matter how busy I am, I have to show my face when the boss is in town," Andrew replied, his demeanor much softer than before.

Initially, Andrew had underestimated Seok-won, attributing his success in shorting the pound to luck rather than skill. However, as they worked together on the NCR deal, Andrew came to respect Seok-won's keen insight and acumen, realizing that his earlier successes were no fluke.

"What can I get you to drink?" Daisy asked.

"Coffee, please," Seok-won answered.

"And for you two?" Daisy turned to Landon and Andrew.

"We'll have coffee as well. Make mine strong, no sugar," Andrew added.

Daisy nodded and left the room.

As Andrew sat across from Landon, he handed Seok-won a slim file he had been holding under his arm.

"What's this?" Seok-won asked.

"It's a performance report for the first two weeks since the start of the year," Andrew replied.

In addition to the $1 billion allocated for acquiring NCR shares, Seok-won had secured an additional $100 million in collateral from Salomon Brothers, allowing Andrew and the trading team to invest freely.

Seok-won opened the file and slowly reviewed the report.

"A return of 8.8%—not bad," he noted.

Given that the current Federal Reserve interest rate was 3%, it wasn't an extraordinary performance, but it was solid enough.

Andrew shrugged modestly at Seok-won's remark.

"It's nothing compared to the 54% return you made on the NCR shares, boss."

Closing the file, Seok-won placed it on the table and leaned back in his chair.

"The FTC is still reviewing the deal, so that return isn't locked in yet," Seok-won reminded them.

The Federal Trade Commission (FTC) was a presidential body responsible for regulating monopolies and unfair trade practices. One of its main tasks was to review mergers and acquisitions (M&As) to ensure they didn't violate antitrust laws.

Andrew, his neatly combed hair shining, smiled confidently.

"There were some initial concerns, but those have since quieted down. The FTC review is proceeding smoothly, so it's only a matter of time before we get approval."

Landon, seated nearby, chimed in.

"I agree. If there were any issues, the FTC would have raised them by now."

"Exactly. You can see the optimism in the NCR stock price, which has been rebounding as the likelihood of the deal going through increases," Andrew added.

After initially soaring and then dropping, NCR's stock price had bounced back, hovering around the $105 per share acquisition price.

"So, when do you think the FTC review will be completed?" Seok-won asked.

"If everything continues without any surprises, we should have a decision by March at the latest," Landon estimated.

"Good, at least it won't drag on too long."

At that moment, Daisy returned, carrying a tray of coffee cups, which she placed in front of each of them before quietly leaving the room.

Seok-won took a sip of the coffee, pleasantly surprised by Daisy's brewing skills. The taste brought a satisfied smile to his face.

"Looks like it's time to start planning our next investment," Seok-won said, setting down his cup.

Andrew's eyes sparkled behind his gold-rimmed glasses as he leaned forward.

"Do you have something in mind?"

Landon, too, looked at Seok-won with anticipation.

Leaning back on the sofa, Seok-won allowed a meaningful smile to play on his lips before he spoke.

"Recently, I've been intrigued by bonds from Spain and Italy."

His statement caught both men off guard, and they exchanged puzzled glances.

"Bonds?" Andrew asked.

"Yes, bonds," Seok-won confirmed.

"But why…?" Andrew trailed off, trying to understand the rationale behind Seok-won's interest.

It was then that Andrew seemed to have an epiphany.

"Are you aiming to capitalize on the yield curve like Mondale Partners?" he asked.

"Exactly," Seok-won replied.

Mondale Partners was a hedge fund founded by the renowned investor Mondale. Established in 1979, it was an old fund that primarily focused on bond trading.

"I've heard that Mondale Partners made quite a killing in the bond market," Landon remarked, his interest piqued.

"Yes, they were quite the talk of the town last year, especially after posting a 48% return, even after fees," Andrew explained, prompting a low whistle from Landon.

"Wow, that's impressive. For a fund of their size to achieve a 48% return… no wonder everyone was talking about it," Landon said, his hands gesturing widely as he spoke.

Seok-won nodded, keeping his tone measured.

"When the Fed slashes interest rates and essentially hands you bags of dollars, making money becomes almost too easy, don't you think?"

Mondale Partners had indeed taken advantage of the Federal Reserve's drastic rate cuts, spurred by the savings and loan crisis. The fund borrowed massive amounts of short-term loans at rock-bottom interest rates and then invested heavily in high-yield long-term bonds, profiting from the difference in interest rates.

'If you buy $100 million worth of long-term bonds and net just a 2% spread, that's a cool $2 million in profit,' Seok-won thought.

Mondale Partners didn't stop there. They used the purchased bonds as collateral to secure even more loans, repeating the process to maximize leverage.

'Leverage is the default setting on Wall Street,' Seok-won mused.

Moreover, as the Fed continued to cut rates to stave off economic recession, not only did the yield curve widen, but the value of the long-term bonds they held also increased, adding capital gains to their income.

'It was a case of having their cake and eating it too,' Seok-won reflected.

Thanks to this strategy, Mondale Partners had been raking in record profits for years, with bonus parties becoming a regular occurrence.

"With other hedge funds also jumping into the bond market, following Mondale Partners' lead, there's no reason we should miss out on the fun," Seok-won stated confidently.

Andrew, adjusting his glasses out of habit, responded cautiously.

"Mondale Partners' returns are remarkable, but the key to their strategy is scale. To achieve meaningful returns, the investment amount needs to be substantial."

"Exactly. Even with leverage, the larger the investment, the bigger the returns," Seok-won agreed, then added almost casually, "How does $3 billion sound?"

"Excuse me?" Andrew blurted out, taken aback.

Landon, equally shocked, stared wide-eyed at Seok-won. Realizing he had reacted too strongly, Landon leaned forward, speaking quickly.

"Where are you going to get that much money?"

Seok-won responded as if it were the most natural thing in the world.

"I think it's time to cash out on the FTSE 100 positions in London. The market has come up quite nicely."

Finally understanding the source of the funds, Landon let out a soft "Ah," nodding.

"That makes sense. The FTSE 100 index has indeed risen significantly."

After shorting the pound, Seok-won had also bet on the FTSE 100's rise, netting an additional 30.1% return.

In just two moves, he had grown his assets to $570 million—a substantial increase.

"Excluding the funds tied up in the NCR shares, I'm using $300 million as collateral to secure tenfold leverage from Salomon Brothers," Seok-won continued.

Andrew grinned broadly, revealing his white teeth.

"That should be more than enough to achieve the returns you're aiming for."

"Great. I've arranged for the trading account to be set up by next week, so coordinate with Salomon Brothers and get the ball rolling."

"Understood," Andrew confirmed.

At that moment, Landon, still looking puzzled, spoke up.

"But boss, why are you looking at Spanish and Italian bonds instead of U.S. bonds?"

Given the scale and other factors, U.S. bonds would have been much easier to trade. Andrew also seemed curious about this choice.

"U.S. bonds are easy to trade, but that also means there's a lot of competition," Seok-won pointed out.

Indeed, as more hedge funds followed Mondale Partners into the bond market, competition had intensified, and the initial high returns had diminished.

"No matter how big the pie is, it's better to find a new opportunity than to join the crowded fight for a slice of it."

"Hmm. That's a fair point," Andrew conceded, his face tightening slightly as he agreed with Seok-won.

"And there's one more reason. You're aware of the ongoing efforts by European countries to issue a single currency, right?" Seok-won continued.

"Yes," Andrew replied.

"I've heard that's been a hot topic lately," Landon added.

After Britain's humiliating defeat on Black Wednesday, when the Bank of England had to abandon the ERM, the push for a European single currency had faced a serious setback. However, the European Community (EC), led by Germany and France, had quickly regrouped, deciding that a lack of economic integration had left them vulnerable to external attacks. This realization had only strengthened their resolve to push for a single European currency.

"The ERM crisis highlighted the need for a single currency, but before that can happen, the interest rates of European countries need to be aligned. That means…" Seok-won trailed off, letting his companions connect the dots.

"It means that Spain and Italy, which have maintained higher interest rates due to their higher inflation, will have to lower their rates to align with Germany!" Landon exclaimed, finishing Seok-won's thought.

Landon's understanding was sharp, even impressing Seok-won, who acknowledged that Landon had broadened his financial knowledge significantly.

Andrew, the professional, seemed to realize this a bit later, but the important thing was that they both understood.

"In order to match the German benchmark, Spain and Italy, which have been maintaining a base rate of around 12% due to inflation, will have to lower their rates by over 4%," Seok-won explained.

Having quickly run the numbers in his head, Andrew's eyes lit up with excitement.

"If those yields are on the table, then investing in Europe over the U.S. makes perfect sense," Andrew said.

"Exactly."

Seok-won glanced at the two men, a wide grin spreading across his face.

"They're throwing a party by publicly announcing their plans for a single currency and interest rate adjustments. Why wouldn't we join in?"

"A party full of tempting dishes and attractive ladies? No way we'd miss that!" Landon quipped.

"Exactly," Andrew agreed, his smile growing wider as he envisioned the lucrative opportunities ahead.

Already, both men were mentally calculating how to maximize their profits from this new venture.

"The stage is set, so let's make the most of it," Seok-won declared, downing his coffee in one gulp, already anticipating the day when the cup in his hand would be filled with champagne.

TL/n - 

When interest rates rise, bond prices typically fall, and when interest rates fall, bond prices generally rise. This inverse relationship is due to the fixed nature of bond coupon payments.

***

Bonds are essentially loans you give to companies or governments in exchange for regular interest payments (called coupons) and the return of your principal when the bond matures. The key point is that these interest payments are fixed when the bond is issued.

Inverse Relationship Explained

When Interest Rates Rise:

New bonds are issued with higher interest rates. If you already own a bond with a lower interest rate, it becomes less attractive because you could get a better return with the new bond. To sell your older bond, you would need to lower its price so that the yield (effective return) matches the higher rates of new bonds.

Example:

Imagine you have a bond that pays $50 a year (5% coupon on a $1,000 bond).

If new bonds are issued that pay $70 a year (7% coupon), your bond isn't as appealing anymore.

If you want to sell your bond, you might have to drop its price to $900 so that a buyer can still earn a comparable yield.

*

When Interest Rates Fall:

New bonds are issued with lower interest rates. Your bond, which pays $50 a year, looks more attractive now because new bonds might only pay $30. You could sell your bond for a higher price because it offers a better return compared to new issues.

Example:

If interest rates drop and new bonds pay only $30 a year, your bond paying $50 becomes desirable.

You could sell it for $1,100 because buyers would prefer your bond over the new one. Summary

*

So, in simple terms: when interest rates go up, the prices of existing bonds go down because they pay less than new bonds. When interest rates go down, the prices of existing bonds go up because they pay more than new bonds.

This helps explain why bond prices and interest rates have an inverse relationship!