- #1
John Creighto
- 495
- 2
For fun I showed this to my parents. They don't have the guts to play spreads. I have no money to invest so, tell me what you guys think.
Why Short Long Bonds
If my calculations are correct a drop in the 30 year treasury to 2% from 3.22% would result in 21.3% capital gain on a long position or equivalently a 21.3% capital loss in the short position. However, a rise in the 30 year treasury to 4.42% would mean a 61.36% loss on the long position or a 61.36 % gain on the short position.
Spreadsheet
Yield Curve Data
So basically their is much more upside potential in the interest rate then downside potential. 30 year rates are at historic lows. The problem is that interest rates can remain low for periods as long as 10 years.
"The markets can remain irrational longer then I can remain solvent"
by John Maynard keynes
The other problem is that it is difficult to find brokers that will short bonds. Their are altra short ETFs
http://www.smartmoney.com/investing/stocks/ultrashort-etfs-could-be-sweet-for-bond-fans-23178/
For instance the:
ProShares UltraShort Lehman 20+ Yr (ETF) (Isn't Lehman bankrupt?)
http://finance.google.com/finance?q=NYSE:TBT
These are nice because they give 2x leverage so in theory you could double your gains. However, the problem with ETFs is because of the way constant leverage works they lose money to volatility:
http://www.morningstar.ca/globalhome/Industry/News.asp?Articleid=ArticleID12920081521
Thus they may not perform the way you think.
The other problem is that if you borrow a stock/bond on a short play, rather then converting the money to cash and buying it back later, you could reinvest that money in something which is higher yielding (Play the spread). I thought I heard mention on the business chanel of some AAA debt yielding 17%. Not sure if you can find that kind of yield but 10 yeer AAA rated municipal bonds are yielding 5.12% on average.
http://finance.yahoo.com/bonds/composite_bond_rates
well the 30 year treasury yields 3.22%.
As for borrowing costs, some brokerages (e.g. Interactive broker) will let you borrow at 1.6% or less for your shorts. This borrowing cost is less then the spread between the 30 year treasury and the 10 year AAA municipal bond.
According to the following link:
http://www.rotman.utoronto.ca/~hull/DownloadablePublications/CreditSpreads.pdf
a triple A bond is suppose to (if you believe the rating institutions) have a default rate of 4 basis points per year or equivalently a 0.04% chance of default per year. This is equivalent to a 0.6% of default over 10 years. These bonds are at historic lows because finical institutions had to sell off a large amount of debt to recapitalized. If you can find a way to invest on the spread between the 10 year municipal and the 30 year treasury you expect to make money, on the interest spread, a flattening yield curve and a decrease on the spread between corporate bonds and treasuries as the market improves. One problem is timing. Another problem is do you trust the rating institutions. Not long ago Fannia May was rated as tipple A:
http://www.creditwritedowns.com/2008/05/question-how-is-fannie-mae-aaa-company.html
you think they missed something? Also remember Enron?
Finally do you think the fed is going to want a lot of people shorting US treasuries. Expect governments to try to make this play less profitable.
Why Short Long Bonds
If my calculations are correct a drop in the 30 year treasury to 2% from 3.22% would result in 21.3% capital gain on a long position or equivalently a 21.3% capital loss in the short position. However, a rise in the 30 year treasury to 4.42% would mean a 61.36% loss on the long position or a 61.36 % gain on the short position.
Code:
The Dangerous of Going Long on US Treasuries
Present Yield Curve Scenario One 30 year Scenario Two 30 year
falls to 2% rises to 4.42%
-----------------------------------------------------------------------
Years Yield Future Yield Future Capital Yield Future Capital
Value #2 Value Gain #3 Gain
0.0833 0.09% 1.0001 0.06% 1.0000 0.00% 0.06% 1.0000 -0.01%
0.25 0.07% 1.0002 0.04% 1.0001 0.00% 0.04% 1.0001 -0.02%
0.5 0.44% 1.0022 0.27% 1.0014 0.05% 0.27% 1.0014 -0.22%
1 0.81% 1.0081 0.50% 1.0050 0.20% 0.50% 1.0050 -0.80%
2 0.90% 1.0181 0.56% 1.0112 0.44% 0.56% 1.0112 -1.78%
3 1.16% 1.0352 0.72% 1.0218 0.84% 0.72% 1.0218 -3.40%
5 1.71% 1.0885 1.06% 1.0542 2.07% 1.06% 1.0542 -8.13%
7 2.13% 1.1590 1.32% 1.0964 3.58% 1.32% 1.0964 -13.72%
10 2.72% 1.3078 1.69% 1.1824 6.45% 1.69% 1.1824 -23.54%
20 3.51% 1.9936 2.18% 1.5393 15.86% 2.18% 1.5393 -49.84%
30 3.22% 2.5877 2.00% 1.8114 21.13% 4.42% 3.6602 -61.36%
Yield Curve Data
So basically their is much more upside potential in the interest rate then downside potential. 30 year rates are at historic lows. The problem is that interest rates can remain low for periods as long as 10 years.
"The markets can remain irrational longer then I can remain solvent"
by John Maynard keynes
The other problem is that it is difficult to find brokers that will short bonds. Their are altra short ETFs
http://www.smartmoney.com/investing/stocks/ultrashort-etfs-could-be-sweet-for-bond-fans-23178/
For instance the:
ProShares UltraShort Lehman 20+ Yr (ETF) (Isn't Lehman bankrupt?)
http://finance.google.com/finance?q=NYSE:TBT
These are nice because they give 2x leverage so in theory you could double your gains. However, the problem with ETFs is because of the way constant leverage works they lose money to volatility:
http://www.morningstar.ca/globalhome/Industry/News.asp?Articleid=ArticleID12920081521
Thus they may not perform the way you think.
The other problem is that if you borrow a stock/bond on a short play, rather then converting the money to cash and buying it back later, you could reinvest that money in something which is higher yielding (Play the spread). I thought I heard mention on the business chanel of some AAA debt yielding 17%. Not sure if you can find that kind of yield but 10 yeer AAA rated municipal bonds are yielding 5.12% on average.
http://finance.yahoo.com/bonds/composite_bond_rates
well the 30 year treasury yields 3.22%.
As for borrowing costs, some brokerages (e.g. Interactive broker) will let you borrow at 1.6% or less for your shorts. This borrowing cost is less then the spread between the 30 year treasury and the 10 year AAA municipal bond.
According to the following link:
http://www.rotman.utoronto.ca/~hull/DownloadablePublications/CreditSpreads.pdf
a triple A bond is suppose to (if you believe the rating institutions) have a default rate of 4 basis points per year or equivalently a 0.04% chance of default per year. This is equivalent to a 0.6% of default over 10 years. These bonds are at historic lows because finical institutions had to sell off a large amount of debt to recapitalized. If you can find a way to invest on the spread between the 10 year municipal and the 30 year treasury you expect to make money, on the interest spread, a flattening yield curve and a decrease on the spread between corporate bonds and treasuries as the market improves. One problem is timing. Another problem is do you trust the rating institutions. Not long ago Fannia May was rated as tipple A:
http://www.creditwritedowns.com/2008/05/question-how-is-fannie-mae-aaa-company.html
you think they missed something? Also remember Enron?
Finally do you think the fed is going to want a lot of people shorting US treasuries. Expect governments to try to make this play less profitable.
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