Betting on higher interest rates has thus far been a losing proposition as long term government bond yields dropped to yearly lows, rising only after Fed officials discussed a broad plan to tighten economic policy at its mid-April meeting. Knowing that the big moves take time and that rates were considerably higher even earlier this year, for now I'm sticking with the trade.
There's another way to consider taming the bond market right now: a spread trade such as the Corporate/Treasury bond spread. Once an esoteric strategy, the trade is now easy to implement for investors of any size.
A spread trade is a position in which two securities, called legs, are traded simultaneously. One security is sold while the other is bought; the investor aims to profit from either the widening or narrowing of the difference between the two, known as the spread. It's a trade based on a relationship, not an outright directional bet on the market.
Generally speaking, corporate bonds yield more than Treasuries because corporations can and do go bankrupt, while the US government's debt is thought to be risk-free. The spread between yields on corporate and Treasury Bonds is one indicator of the market's perceived difference in risk between government and corporate debt. The wider the spread, the more risky corporate bonds are thought to be.
Source: Rosewood Research, Bloomberg LLP
During the depths of the financial crisis corporate credit risk was virtually dumped, leading to a massive spike in corporate bond yields and some of the highest spreads on record.
Although it has shrunk considerable since the collapse, the spread between the yield on corporates and treasuries remains historically wide, meaning that corporate bonds are still yielding considerably more than treasuries of the same maturity, even at today's low rates. A more normal spread would mean either corporates should yield less, treasuries should yield more, or some combination of the two.
That outlook could be established simply by buying shares of Vanguard Intermediate-Term Corporate Bond Index ETF (VCIT),
The profit - or potential loss - would be tallied not only from the interest earned on the corporate bonds (and paid on the short-treasury position) but the relative price performance of the ETFs themselves. Rising prices for bonds correspond with falling yields.
A major risk would be that the yield on corporate bonds jumps even as the yield on government bonds falls, causing the spread to widen as it did during the 2008-2009 panic. Investors who foresee this trend could "sell the spread" by buying Barclays 7-10 Year Treasury (IEF)
Given that our government now borrows $58,000 a second, recently had its debt outlook downgraded to negative by Standard & Poor's Ratings Services and is technically just 11 weeks away from default, an equally probable scenario is that the spread collapses; that the perceived credit risk in holding Treasuries pushes yields higher, potentially even higher than corporates bonds, as is often the case in financially distressed countries where blue chip companies are managed even more prudently than the government itself. Ring a bell?
Jonathan Hoenig is managing member at Capitalistpig Hedge Fund LLC