Seems to me time to look at PST short 7-10 yr treasuries I bought some a while ago mostly thinking inflation would kick in and the principle would drop, but a weak dollar does the same as does a Fed which starts to raise rates.
Using ETFs to Find Equity-Beating Returns in Bonds
* Paul Justice, CFA
* On Wednesday May 13, 2009, 7:00 am EDT
*
Buzz up!
* Print
Related:
* SPDR Barclays Capital High Yield Bond
* , SPDR Barclays Capital Long Credit Bond
* , UltraShort 7-10 Year Treasury ProShares
In the wake of a furious market rally over the last few weeks, and all sorts of talk about "green shoots" popping up, one would think that all of the most recently published economic data being produced is decidedly positive. I regret to say that it is not. Granted, we have seen some relatively better numbers recently than we had just three months ago, but those are comparisons against an awfully low standard. There have been no "all clear" signals distributed, but disaster no longer seems imminent.
Related Quotes
Symbol Price Change
JNK 35.36 +0.16
Chart for SPDR BARCLAY HYB ETF
LWC 32.61 +0.07
Chart for SPDR BARCLAYS CAPITL
PST 59.62 -0.70
Chart for PROSHARES ULTRASHORT 7-10 YEAR
TBT 57.22 -0.07
Chart for PROSHARES TRUST
{"s" : "jnk,lwc,pst,tbt","k" : "c10,l10,p20,t10","o" : "","j" : ""}
While the economy will no doubt resume growing at some point, I lack the foresight to say when that will happen and from what base we will begin anew. In a nutshell, there is plenty of uncertainty in today's market. That said, let's not forget that there is always some uncertainty in investing. Risky asset classes, like stocks and corporate bonds, do not always go up. If they did, they would be called risk-free. In fact, orthodox financial theory claims that systemic risk is the only source of long-term returns above the risk-free rate paid on cash deposits. If an investor could avoid all risk simply by purchasing a broad basket of world stocks and bonds, everyone would jump into the markets to try to capture the outsized returns. The returns on stocks and corporate bonds would then be equal to Treasury yields.
Anytime most investors agree that there are no systemic risks to investing--which seemed to happen multiple times over the past decade--the market en masse seems to err. Stock prices get too high, equity risk premiums disappear, and a "Black Swan" event, such as a credit crisis, strikes.
So now that the market is offering healthy compensation for taking risks, those of us with strong stomachs have plenty of opportunities to capture premiums. We are not talking about finding free lunches, but the good deals are plentiful for both risk-tolerant and risk-averse investors alike.
Subscribers to our Morningstar ETFInvestor newsletter are familiar with my dislike of uncertainty. We began selling funds in September 2008, and, as recently as March, the cash allocation of our tactical Hands On portfolio peaked at approximately 60%. However, we started putting capital to work four weeks ago and expect to be nearly fully invested in short order. Below, I'll provide some insight into a trade that we recently placed to take advantage of a nice upside opportunity with fairly low risk in an area often ignored by individual investors--a tactical position in investment-grade bonds.
We made a relatively complicated trade using three ETFs to capture a single pronounced deviation in today's markets: the large spread between corporate bonds and Treasuries. We are not alone in our thinking: Mark Kiesel from PIMCO recently posted his take on this phenomenon here. Even when the stock market hit new lows in March, these credit spreads between Treasury bond yields and those of other investment-grade and junk bonds continued to look like a better deal than equities. Bond prices suggested a wave of defaults as large as the Great Depression on the horizon, which we (and the stock market) felt was deeply unlikely.
The big question was how to invest in this opportunity with enough leverage to get returns equivalent to those on offer in stocks. For this, we needed long duration bonds (such as 10-year bonds as opposed to one-year), because duration provides natural leverage in bond prices. Unfortunately, the first ETF covering long-term investment-grade bonds did not incept until mid-March and took a few weeks to build its portfolio. But today, bond prices still include a gloomier outlook than stock prices, and we finally have a way to invest in those panicked credit spreads coming down: SPDR Barclays Capital Long Term Credit Bond (NYSEArca:LWC - News). We could have used SPDR Barclays Capital High Yield Bond (NYSEArca:JNK - News) in a similar trade, but we felt that junk bonds do not offer enough upside compared with their considerably higher risks.
Inflation remains one of our prominent concerns for the intermediate future, and one that particularly afflicts bonds' fixed nominal payments. To guard against higher inflation and the consequent rise in bond rates, we need to short Treasury bonds that match the duration of LWC, allowing us to isolate just the credit spread between investment-grade bonds and Treasuries. In fact, we expect the short side of our trade to pick up at least half of the potential profits as inflation fears push up yields across the board.
No fund currently exists that shorts the Barclays Capital 10-20 Year Treasury Index, which matches the duration on LWC almost perfectly. Instead, we have to use a blend of UltraShort 7-10 Year Treasury ProShares (NYSEArca:PST - News) and UltraShort 20+ Year Treasury ProShares (NYSEArca:TBT - News) to try to match the duration. For more details on how we structured this trade, we invite you to subscribe to our newsletter.
The most likely criticism that we'll receive regarding this trade is our use of two leveraged-inverse ETFs as hedges. After all, we did write an article back in January titled "Warning: Leveraged and Inverse ETFs Kill Portfolios." Our stance on leveraged equity sector funds remains the same; we think they are inappropriate for investors to hold for periods greater than a few days. However, our stance regarding Treasury issues is more muted.
Why is that? The component that causes leveraged and inverse ETFs to perform unexpectedly over longer holding periods is volatility, or the standard deviation of returns. When using leveraged funds, performance drag grows as the underlying index moves more violently. The reason is that leveraged ETFs follow a constant proportion strategy, or one that buys more of an asset after it goes up and sells after it goes down. This is the opposite of traditional asset-allocation strategies that rotate out of one sector after it goes up while moving resources into the asset class.
When volatility rises, a leveraged fund buys and sells at inopportune times. We know that equity sector ETFs are generally more volatile than diversified equity indexes (like the S&P 500), and fixed-income investments are considerably less volatile than equities. The least volatile of investment classes are those with the lowest risk, and short-term U.S. Treasuries are often called "risk-free" securities given their explicit backing by the owners of the money-printing press, the federal government.
While we are avoiding default risk by using longer-dated Treasuries in our leveraged short position, we are still incurring some duration risk, which will add some volatility to our positions. However, we don't believe that the future volatility will be substantial enough to make this idea infeasible.
If you decide to execute this trade as well, keep in mind that LWC is a new offering with very limited assets under management and trading volume. While these factors alone should not scare you away from the trade, be sure that you execute your orders effectively. We strongly suggest the use of limit orders that are close to the listed net asset value of the fund. Furthermore, if you are considering purchasing several thousand shares of LWC, it never hurts to call a liquidity specialist at the issuing firm. The market makers have enough incentive to execute your trade at a fair price, but the execution may not be immediate. Do not allocate a substantial portion of your portfolio to this trade if you value liquidity; getting out may also take some time. We hope that LWC's assets under management will grow considerably over the next year (given its fairly distinctive market segment), which should allow an easier exit should our thesis hold true.
Paul Justice, CFA has a position in the following securities mentioned above: TBT PST LWC
AI
