30 Year Treasury/10 Year AAA Bond Spread

[John Creighto]

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.

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%

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.

 

[mheslep]

Certainly many financial pundits are saying there's a treasury bubble in place now with the flight to quality.

 

[BWV]

your calculations are incorrect

the % change going from 3.22 to 2.00 is approximately 27%

the % change going from 3.22 to 4.42 is approximately -20%

you can use the price function in excel to get these results.

Without looking at your math, to see the problem just calculate the bonds as if they were perpetual (i.e. pmt / interest rate) which would be a greater gain or loss than that of a 30 year maturity

going from a perpetuity with a 3.22% yield to a 4.42% yield is a change in value of -27%

As non-callable bond prices are convex, the absolute value of % change of the price due to a decrease in the discount rate will always be greater than the absolute value of the % decrease due to an increase in the discount rate

 

[JakeA]

The US is going to have to start printing money in order to fix its economy and pay off its debt. There's no other realistic fix to the problems we're having. Expect hyper inflation because of it. I wouldn't be making any bets on 30 year Treasury rates staying low. It may not happen this year or next, but certainly within the next decade.

 

[CRGreathouse]

Expect hyper inflation because of it.

Do you really mean that? Hyperinflation sounds more than a little extreme to me.

 

[JakeA]

Just looking at nominal monetary investments, you see that there is way too much money chasing increasingly few returns. The only way to remedy the situation is through monetary inflation.

But my reasoning for inflation was something related, but slightly different. There's no way the US is going to be able to deal with its debts in the future without printing money out of thin air. I know it seems like we're printing money already, but we aren't. Technically we're borrowing it, sometimes from ourselves. What needs to happen is creating money without borrowing it. That's fundamentally inflationary.

Also, the US economy is way too heavily invested monetarily. Wages by comparison are way too low. The only way to remedy this situation is with wage inflation which in turn leads to overall monetary inflation.

Right now we're in a deflationary period. We're also going have to induce inflation to deal with it. Deflation is REALLY bad for economies, unless you have a ton of money holed up somewhere.

Inflation can be good for economies if it doesn't get out of control. BTW, we already had a sort of hyperinflation in housing that wasn't picked up by economists because they're too stupid to realize that housing costs need to go into the inflation/deflation equation.

 

[JDGreen]

Several points from an investment strategist who happened to stumble on this forum:

1) There is a difference between "then" and "than". "Then" is used for an association of two events over time. E.g. "We went to the store and then had ice cream." "Than" is used to relate to values. E.g. "Thing A is better than thing B." The same applies to "their" and "there", as in "There are ultra short ETFs." Also note that the word us "ultra" not "altra". It's generally a good idea to be skeptical of an article giving financial advice, authored by someone who cannot write.

2) Lehman Brothers is indeed bankrupt, however the title of that ETF refers to an index which they created, and as such it is not relevant. In fact, Barclay's Capital has since bought many of Lehman's business lines and now uses their names on the indexes.

3) The reason AAA bonds, or Aaa3 bonds depending on who is doing the rating, essentially never default is that the issuer is always downgraded in advance of the default. That is to say, if the rating agencies sense credit problem's brewing they sweep in and say "Well, you're no longer AAA, we are downgrading you to BB." Though it's generally done in steps, and generally after everyone knows there are issues, you get the idea.

4) As noted in the article, the use of so-called "constant leverage" products will almost never replicate an exact multiple of an underlying securities return over an extended period. These instruments were designed for short-term trading, and using them otherwise can be quite damaging. There are articles on this topic all over the web, so I won't bother to take on the details here.

5) If the US does just start "printing money" then you believe this will cause inflation. If we have "hyper-inflation" as you put it, then the yields on long bonds will soar. This also means that the prices of current issues of long bonds will fall sharply. Yields and prices move inversely. If you believe this will happen, then shorting long treasuries is a good strategy (but again, beware of the risks of the leveraged short). However, keep in mind that it is difficult to cause hyper-inflation when you have a 9-10% unemployment rate. Again, there are dozens of articles on Phillips curves and the inverse relationships between inflation and unemployment levels which you can read for more information.

6) Lastly, you are discussing the most dynamic and complicated type of spread - called "diagonal". Spreads, in the case of bonds, are simplest between two securities of the same maturity, or the same default rates. You are discussing a spread between two securities which differ on both variables. Additionally, you are looking at two securities with different liquidity properties and different taxation. If you are just getting started with spreads, you would be better off consulting a professional, or at least keeping it a bit more simple. For example, play between a 20 year AAA muni and a 20 year treasury. Now your maturities and default risks are essentially the same. You most definitely do not want to engage in spread with leveraged ETFs - this would be fundamentally flawed for the reasons discussed before.

I have profited significantly in recent months with DXO, and TBT, leveraged oil and treasury ETFs. However, I understood the risks when I purchased them and you should be sure you do the same before you act. If you are making an investment without at least superficially understanding the risks you are taking, you are essentially gambling.

 

[mheslep]

...
5) ... However, keep in mind that it is difficult to cause hyper-inflation when you have a 9-10% unemployment rate. Again, there are dozens of articles on Phillips curves and the inverse relationships between inflation and unemployment levels which you can read for more information...

No, one can not waive away inflation concerns under an exploding money supply with a reference to classical Phillips. The reading will quickly show you that the classical macro shallow Phillips curve need not apply. See Phelps, Friedman, stagflation, and NAIRU. Unemployment and inflation can (and have) both increase(d) at the same time. The Phillips 'curve' can go vertical.
"inflation is always, and everywhere, a monetary phenomenon.” - Friedman & Schwartz
http://www.econlib.org/library/Enc/PhillipsCurve.html
http://www.chartingstocks.net/wp-content/uploads/2009/03/money-supply.gif

 

[junglebeast]

Whoa...I didn't know that the monetary base DOUBLED from 2008 to 2009!

Now I'm trying to think what this actually means. Does this mean that the amount of wealth in the US economy has doubled due to money printing?

Or is this a result of everyone tearing their money out of the stock market as fast as they could, which is just transferring what wealth they have left from assets into capital?

The latter case makes more sense to me, because that seems like a direct result of the market crash, and what it essentially means is that the it represents a massive de-inflation of the market due to defaults from corporate bankruptcies, meaning that the value of money has actually increased.

But now that the banks have all this extra money, they will probably start loaning it out and this will result in a huge monetary inflation...possibly cutting the current value of money in half over the next couple years, and the only safe thing to do would be to invest in low-risk stocks. Thoughts?

 

[mheslep]

Whoa...I didn't know that the monetary base DOUBLED from 2008 to 2009!

Now I'm trying to think what this actually means. Does this mean that the amount of wealth in the US economy has doubled due to money printing?

Or is this a result of everyone tearing their money out of the stock market as fast as they could, which is just transferring what wealth they have left from assets into capital?

The latter case makes more sense to me, because that seems like a direct result of the market crash, and what it essentially means is that the it represents a massive de-inflation of the market due to defaults from corporate bankruptcies, meaning that the value of money has actually increased.

But now that the banks have all this extra money, they will probably start loaning it out and this will result in a huge monetary inflation...possibly cutting the current value of money in half over the next couple years, and the only safe thing to do would be to invest in low-risk stocks. Thoughts?

The expansion is due to money printing by the Fed. Reserve, and unrelated to any of the above.

 

[John Creighto]

3) The reason AAA bonds, or Aaa3 bonds depending on who is doing the rating, essentially never default is that the issuer is always downgraded in advance of the default. That is to say, if the rating agencies sense credit problem's brewing they sweep in and say "Well, you're no longer AAA, we are downgrading you to BB." Though it's generally done in steps, and generally after everyone knows there are issues, you get the idea.

That's interesting. I thought that the ratting was suppose to be based on the expected default rate. However, if that is not the case then what is the basis for the rating?

Anyway, regardless if we also know the downgrade risk for the asset class then we could still establish the risk of the bond defaulting in a given number of years. All we have to do is consider all the possibilities. The possibility of if defaulting well being rated tipple A, the possibility of it being down graded to double B and then defaulting and so on...

 

[BWV]

That's interesting. I thought that the ratting was suppose to be based on the expected default rate. However, if that is not the case then what is the basis for the rating?

Anyway, regardless if we also know the downgrade risk for the asset class then we could still establish the risk of the bond defaulting in a given number of years. All we have to do is consider all the possibilities. The possibility of if defaulting well being rated tipple A, the possibility of it being down graded to double B and then defaulting and so on...

the rating is based upon the likelihood of default, the downgrades in ratings prior to a default are included in the calculations

 

[AaronH]

Thank you for the heads up on the investment vehicles available for shorting treasuries. For now though, as long as the Fed keeps the target rate low, then in theory the yield will stay low, even if the bond rating agencies dumped our credit rating. The Federal Reserve can purchase treasuries, thus keeping demand high and the yield low to match their target rate.

There is some speculation that the Federal Reserve will also yield to political pressure and avoid raising rates, since their mandate also includes employment. So this may be a speculative play after employment levels increase, which will bring inflation pressure.

There is also some political risk here, since the House of Representatives is holding Fed oversight legislation over their heads for the time being. No one knows how that will affect FOMC meetings in the future, when they set target rates. Either way it may not be a bad idea to short treasuries before, or just after mid term elections.

 

[mheslep]

Thank you for the heads up on the investment vehicles available for shorting treasuries. For now though, as long as the Fed keeps the target rate low, then in theory the yield will stay low, even if the bond rating agencies dumped our credit rating. The Federal Reserve can purchase treasuries, thus keeping demand high and the yield low to match their target rate.

The Fed has stopped the large purchases of paper.
http://www.federalreserve.gov/newsevents/testimony/bernanke20100325a.htm

There is some speculation that the Federal Reserve will also yield to political pressure and avoid raising rates, since their mandate also includes employment.

The Fed has no legal mandate to maintain employment, even if they get beat up about in Congress. Starting in the 80's, central banks have concentrated largely on maintaining a stable monetary policy and holding off inflation. They can't do both inflation and employment at the same time.

 

[AaronH]

Actually the Fed has a number of legislative mandates.

The first is:

"Conducting the nation's monetary policy by influencing monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates."

It's true that the treasury purchase program has ended, however the Federal Open Market Committee (FOMC) has set a Federal Funds Target Rate. Although the prinicpal aim is to influence the supply of money, this is accomplished through what is called, Open Market Operations, whereby the Fed will purchase treasuries to inject money into the economy or sell treasuries to take money out of the economy.

When US government bond prices rise, the yield or interest rate declines, and when US treasuries drop in price, the yield or interest rate rises. By purchasing treasuries, the Fed artificially decreases the supply of US government bonds (treasuries) on the open market, and then the price goes up and the target rate is met.

So if the Federal Reserve wants to keep interest rates low for an extended period of time, they will in effect purchase treasuries, with printed money if they have to. This does increse the available money supply.

This in theory should also have an impact on employment. Banks and lenders have a choice of lending money for capital projects, or investing in treasuries at the "risk free rate," provided by US government bonds. If they lend to consumers or businesses they will certainly require that the interest they charge be above what they could get risk free, otherwise loaning money to the government by purchasing treasuries.

If the treasury yield is high, then less projects will get funding because less businesses can get loans, or are willing to take loans at a higher interest rate. If the rate is low, like it is now, then in theory more projects will get funded. If more capital projects are funded, then labor will be employed for those projects, and economic output will rise. Thus not only is economic output affected, but the employment should rise as well.

That is the logic behind the dual mandate of price stability and employment, although I pesonally think it should be to maintain price stability only.

Either way, as long as the target rate is low, then the price of bonds will remain high.

Here is a link to an article on the Federal Reserve's website that details Open Market Operations in more detail.

http://www.federalreserve.gov/pubs/bulletin/1997/199711lead.pdf

 

[AaronH]

Here is a link to the FOMC statement:
http://www.federalreserve.gov/monetarypolicy/fomc.htm