Introduction:
Crypto is widely regarded as a highly volatile asset class, however, interest rates in this domain also display significant volatility, largely due to the extensive use of leverage. In traditional markets, a multi-trillion dollar industry has flourished based on monetizing interest rate fluctuations through a diverse range of derivative contracts. Among these, the conventional fixed/floating interest rate swap is a fundamental and widely utilized instrument among global institutions.
Similarly, as capital continues to flow into the crypto sector, there is a growing interest among investors in speculating on yield fluctuations. In this context, Pendle Finance distinguishes itself as one of the select few protocols offering opportunities for yield speculation. This research note is focused on providing a comprehensive quantitative analysis of Pendle Finance’s unique interest rate markets. Our focus is on identifying and detailing effective strategies that investors can employ to efficiently manage and trade their capital on the platform.
Overview of Pendle:
In the realm of DeFi yields, a significant challenge is their inherent volatility, often reflecting the movements of crypto prices. For instance, yields can soar to impressive figures (such as 20% or more during bull markets), yet their stability is questionable. This aspect contrasts sharply with traditional asset management principles, which emphasize the importance of including uncorrelated assets in a portfolio to achieve better diversification.
Pendle Finance addresses this issue by enabling users to engage in fixed/floating interest rate swaps involving various DeFi interest rates. This feature allows users to separate the fixed and floating components of their investments, providing them with the flexibility to tailor their risk exposures according to their preferences.
Pendle facilitates this by allowing users to deposit yield-bearing assets on the platform. These assets are then converted into two derivatives: a Principal Token (PT) and a Yield Token (YT). In every instance, the combined value of the PT and YT is designed to always equate to the price of the underlying asset. It’s crucial to recognize that the creation of PT and YT does not create new assets out of thin air. Instead, these tokens are fully backed by the collateral deposited into Pendle. PT and YT are distinct products, each with their own unique use-cases, and should be approached and managed accordingly.
This concept can be illustrated with a straightforward example:
Consider Pendle’s stETH DEC2024 implied rate is offered at a 5% yield, while the current underlying yield on Lido is 3%. At the start of 2024, an investor might see this as a favorable opportunity to secure a higher fixed rate for their 1 stETH over the upcoming year.
- The value of the PT today would be calculated as 1 / (1 + 0.05)^(365/365), which equals approximately 0.95 stETH.
- The value of the YT today would be 1 – 0.95 resulting in approximately 0.05 stETH
- Adding PT and YT gives a total of 1 stETH.
In essence, the investor can acquire a one-year zero-coupon bond at a cost of 0.95 stETH today, and is assured to receive 1 stETH upon maturity, thereby securing a fixed yield of 5%. In contrast, holding stETH in Lido would likely yield only a 3% return, with the additional uncertainty of whether this rate would remain stable over the course of the year.
Alternatively, instead of opting for a fixed yield, sophisticated investors may choose to speculate on future yields by acquiring YT. Differing from PT, YT represents the coupon component of a fixed-income instrument. It’s inherent that the value of a YT will diminish to zero at maturity, as all the yields would have been distributed by that time. For instance, let’s examine the performance of PT and YT for the stETH 30MARCH2023 maturity. These tokens tend to exhibit inverse trading patterns, as demonstrated in the following example.
When trading YT, it’s important to understand this involves a speculation that the underlying Lido yield will exceed the implied yield for the duration of the trade. As time progresses, holding a YT position means accruing yield based on the current market’s underlying yield. For instance, if an investor purchases a YT with an implied yield on Pendle for 5%, while the actual underlying yield is at 3%, they are in effect paying a premium for the YT. Should the yields remain constant, this trade would result in a loss, as the investor would have overpaid for the YT at a 5% yield rate but actually only received a 3% yield from the underlying protocol. This scenario highlights an important trading relationship between yields on Pendle:
- In Pendle’s trading dynamics, when the implied yields are higher than the asset’s underlying yield, PT becomes relatively cheaper while YT is considered more expensive. If an investor anticipates that the gap between the implied and underlying yields will stay positive, it makes strategic sense to secure a fixed implied yield by purchasing PT.
- On the flip side, if the implied yields on Pendle are lower than the underlying yield of the asset, PT is relatively more expensive, whereas YT becomes cheaper. In such a scenario, if an investor expects the difference between implied and underlying yields to remain negative, purchasing YT at a lower interest rate may allow the investor to accrue higher returns over time.
The theoretical interplay between implied yields on Pendle and the underlying yields of the asset can be effectively illustrated using a heatmap. This visual tool is designed to showcase the APY for a long YT position across different scenarios. It’s important to note that this analysis assumes interest rates remain constant throughout the trade’s maturity and is intended primarily for illustrative purposes, to demonstrate the relationship between the two types of rates. A key observation from the heatmap is that the most significant YT gains typically occur when the underlying rate exceeds the implied rate.
While the theoretical relationships presented above appear logical, as we will explore further in this report, it’s important to note that real-world market dynamics and liquidity constraints can result in mispricings. Consequently, this can lead to situations where the theoretical understanding may not align precisely with actual market behavior.
Use-Cases For PT:
PTs provide the option to lock in interest rates when they are attractively high, as indicated by the current implied rate in the Pendle market. Since one unit of a PT will always mature to the full value of the underlying asset at maturity, owning a PT is generally more advantageous than holding the underlying asset itself, barring underlying smart-contract risks. This advantage is evident when comparing various investment statistics between holding a PT token and the underlying asset. In every scenario analyzed, such as those measuring Sharpe or total returns, owning the PT demonstrated superior performance from a risk-adjusted perspective. The fixed yield component of the PT token serves as a cushion against market drawdowns and enhances overall returns, an effect that becomes increasingly significant with compounding over extended periods. The PT token is particularly well-suited for passive investors who prefer not to time the market and are comfortable with holding the asset until its maturity.
With stETH having the most number of unique maturities on Pendle, we can utilize its data to construct an interpolated term structure. An intriguing observation from this term structure is that interest rates are generally higher at the short end compared to the longer-dated maturities. This suggests that traders might have the potential to earn higher yields through shorter-maturity trades rather than opting for longer maturities extending up to 2027. This trend in Pendle reflects a well-known pattern observed in traditional finance, where interest rate term structures tend to invert during times of market stress. During these periods, there is a preference in the market for short-term debt compared to longer-term maturities. Specifically for Pendle, this inclination is likely driven by the lower liquidity and smaller trading volumes associated with the longer-dated maturities.
Use-Cases for YT:
YTs designed for active investors who aim to capitalize on the differences between the implied and underlying asset’s interest rates. A key concept to grasp with YT is that their value will gradually decay to zero as the maturity date approaches, coinciding with the completion of coupon payments. According to the Pendle Academy documentation, there are two primary reasons for trading YT:
- Expectation of Higher Underlying Yields: A primary rationale for trading YT is the anticipation that the protocol’s underlying yield will exceed the current implied interest rate. If the underlying yield consistently trades higher than the implied yield, it sets the stage for a profitable trade. For instance, consider an investor who buys a YT at an implied rate of 5%, while the underlying yield at the time of the trade is 8%. Assuming these rates remain unchanged until maturity, the YT holder would effectively realize a 3% spread (excluding fees) from this position. For example, the investor might have paid $5 for the YT initially, but over the duration of the trade, they could accrue $8 in underlying yield, resulting in a net profit of $3. While in reality, rates are unlikely to remain static, understanding this relationship can guide investors to better position themselves for success when buying YT with the aim of accruing additional yield. Such traders can be referred to as spread traders, and this concept can be further illustrated with a chart depicting their strategy.
- Expectations of Increasing Implied Yields: Traders anticipating a significant rise in implied yields may prioritize quick monetization of large movements in these yields, rather than focusing on the current underlying interest rates. Due to the nature of implied yields, which are influenced by market supply and demand within the Pendle protocol, there can be considerable discrepancies between the implied and underlying rates. When implied yields are already higher than the underlying rates, engaging in speculation on a further increase should be strategically approached as a short-term trade. In such cases, traders aim to reduce the duration of their holding period. This is because, while there is potential for profit from rising implied yields, the costs associated with funding the position, including the negative profit and loss due to accumulated yield, can become substantial. This trading style aligns with that of an interest rate trend trader which can be visualized in the chart below.
Discussing the trading dynamics of YT reveals another significant advantage: they offer traders substantial leverage without the risk of liquidation or bankruptcy. To illustrate this, consider a trader looking to speculate on the future yields of YT with a 3-month maturity, where the current implied yield is trading at 5%.
Let’s break down the example:
- Asset Price = $1000
- PT = 1000/(1 + 0.05)^(90/365) = $988.04
- YT = 1000 – PT = $11.96
- YT Notional Exposure = $1000/$11.96 = 83.6x
Given that all assets within the Pendle protocol are fully collateralized, this scenario enables the trader to gain exposure to nearly 83.6 units of the underlying asset without any risk of liquidation. This aspect of YT provides significant flexibility, allowing traders to adopt positions that might be challenging to achieve with smaller account sizes, thereby opening up a broader range of strategic possibilities in market speculation.
Analogy to Options Trading:
In the scenarios described above, trading YT tokens bears resemblance to options trading. Specifically, in the first example, where the trader aims to capitalize on the difference between implied and underlying rates, the strategy is akin to purchasing an option at a low implied volatility while the underlying asset experiences higher realized volatility. Profits in this case are generated through continuous gamma hedging. As the option approaches maturity, its time value diminishes to zero. However, if the realized volatility remains consistently higher, the cumulative profit from gamma hedging should result in a net gain.
In the second example, the approach resembles purchasing an option in anticipation of an increase in its implied volatility, followed by selling it once the market revalues the option. The key here is that the trader does not need to hold the position until maturity, as holding on would result in theta decay and most of the profit from the initial move would have already been realized. This mirrors the strategy of the trend trader who bets on rising implied volatilities, aiming for a swift market move rather than engaging in a longer-term spread trade as in the first example. A notable characteristic of YT, as can be observed, is their significantly higher volatility compared to PT tokens. This makes them particularly suitable for strategies that involve speculating on volatility levels.
When it comes to options trading, investors often purchase straddles when volatility is low to avoid the cost of high volatility. However, low volatility doesn’t automatically translate to profits from buying straddles, especially in the absence of significant market events. While buying straddles at low volatility might increase the probability of profit, it doesn’t ensure it, especially if there’s no substantial event or change in market liquidity. Drawing a parallel, purchasing YT when the implied yield is lower than the underlying yield may increase the likelihood of profit for the trader, but it doesn’t guarantee success. The outcome still hinges on market movements and other factors beyond just the yield rates.
stETH YT Trading Backtest:
To gain a deeper insight into the P&L dynamics of trading YT under varying interest rate conditions, let’s examine the active implied yields for stETH maturities. By looking at the historical data, we can observe the spread between the implied and underlying yields for different maturity dates. Consider the following examples:
- The DEC2024 maturity at its inception was trading at a premium compared to the underlying rate. This is indicated by a positive spread, meaning the implied yield was higher than the underlying yield.
- In contrast, the DEC2025 and DEC2026 maturities were trading at a discount to the underlying rate, as denoted by a negative spread. Here, the implied yields were lower than the underlying yields.
This historical spread between implied and underlying yields can be used to help us understand the P&L implications for YT trading. It highlights how different maturities can exhibit varying levels of premiums or discounts, influencing the decision-making process and potential profitability for traders in the Pendle market.
When analyzing the P&L of holding various YTs over a six-months pattern, this bears a resemblance to what is typically seen in systematically buying options: a consistent and gradual decline in P&L with periodic spikes of positive gains. A key observation from this period is the shift in returns around mid-October 2023. This shift coincides with the point where, for the first time, the implied yields exceeded the underlying yields across all maturities. This meant that the implied yield was now greater than the underlying yield for each maturity. However, the momentum in the spread between implied and underlying rates shows a relatively weak correlation with the overall P&L from holding YT.
This analysis suggests that simply relying on the strategy of buying and holding YT, with the expectation that higher implied yields over underlying yields will lead to profit, may not be conclusive. The results from this backtest indicate that a more nuanced, discretionary approach, perhaps focusing on special situations, might be more effective for actively trading yield contracts. This approach requires a deeper understanding of market dynamics and timing, emphasizing the importance of strategic decision-making in trading YT.
As an important consideration, it’s worth noting that this analysis primarily focuses on stETH, which, at the time of this writing, has one of the largest liquidity pools on Pendle. The underlying Lido yields for stETH tend to be relatively stable and do not typically experience high volatility. This stability in the underlying yield means that trading YT based on stETH may not be as profitable, as the expected movement in yields is limited.
Specifically for stETH, there has been an observed correlation between an increase in TVL and a decrease in Lido yields which can be visually confirmed by data from DeFiLlama. This is logical, as a larger number of validators in the network typically results in a reduction of staking rewards on average. With this trend likely to persist, it’s reasonable to anticipate a continued reduction in rate volatility. Consequently, this could make active trading of YT in stETH less attractive due to the diminished potential for significant yield fluctuations.
Given these factors, traders might find it more beneficial to explore other pools within Pendle that are associated with more volatile interest rates. These pools could potentially offer more lucrative opportunities for active YT trading. In the following section, we will delve into an alternative option and analyze its prospects in greater detail.
Special Situation Case-Study: Ether.Fi weETH 27JUN2024
In this particular case, we observe that the implied yield consistently trades higher than the underlying yield. This is because traders are highly incentivized to hold YT due to the additional rewards of Eigenlayer and ether.fi points. It’s important to note that many traders purchasing YT in this situation may not be focusing solely on accruing gradual yield. In fact, they might even accept potential losses from purchasing overpriced YT, anticipating a future token allocation.
However, it’s crucial to emphasize that, by design, the value of the YT will inevitably decay to zero upon reaching maturity. Traders must carefully evaluate whether the potential benefits from airdrops and accumulated yield until maturity will outweigh the current cost of the YT. A detailed analysis of the mechanics of this trade and various possible scenarios has been compiled by Pendle Intern, offering insights into strategic approaches.
This market anomaly provides a unique opportunity for buy-and-hold investors. They can purchase PT and lock in an attractive 30% APR yield on weETH, with the added benefit of no liquidation risk and all yields paid in the native currency, which is a relatively rare occurrence. Additionally, traders looking to accumulate points without downside risk exposure can structure their investments akin to a principal protected note. This strategy involves purchasing both PT and YT and holding them both until maturity. At expiry, the PT will be redeemable for one full unit of weETH, while the YT will reduce to zero. Despite the decay of the YT, the trader would still retain full exposure to the rewards from Eigenlayer and ether.fi points, offering an appealing strategy for those prioritizing speculative gains over consistent yield while avoiding any downside risk.
Conclusion:
Pendle Finance is emerging as a trailblazer in the DeFi sector, leading the evolution of interest rate derivative protocols. Well-structured interest rate markets are a cornerstone of any advanced economy, and a similar trajectory is observable in the DeFi space. Looking ahead, there’s potential for other protocols to leverage Pendle’s fixed income instruments as building blocks to create innovative products with unique payoff structures.
The flexibility of PT, as demonstrated in the ether.fi pool case study, is a prime example of their potential for integration with other DeFi protocols. For instance, an on-chain derivatives protocol could combine PT with call options to construct a principal protected note, offering investors the chance to benefit from crypto price appreciation while ensuring the safety of their principal.
As the market for crypto interest rate derivatives matures, we expect to see enhanced liquidity and improved price discovery, particularly for longer-dated maturities. This progression is poised to introduce new strategies and trading signals, thereby enriching the DeFi interest rate market landscape. Pendle is at the forefront of this dynamic evolution, positioned to be a key player in driving the growth and sophistication of DeFi interest rate markets.