TLT Options: Taking Advantage of Interest Rates

Risky assets have taken the front stage as investors clamor to increase the yields within their portfolios. Because of the flight away from quality, treasury securities have fallen slightly out of favor and 30 year yields have crept up to about 4.3%. There have been many comparisons between the current US economic environment and that of Japan in the 1990s and I want to explain where that comparison falls apart. Japan entered their malaise as a country of savers whereas the United States entered its crisis with a heavy burden of debt. That is a very important distinction that has swayed me towards a trade that I think has a very high probability of being right.

If we believe in any recovery in the world economy then I think it is safe to say that we will not see 30 year treasury yields hit 2.5% as they did on December 18, 2008. Those yield levels were crisis levels. That occurred when there was an extreme flight away from all risky asset classes and into safe assets such as treasury bonds and agency backed mortgage securities. At the time, it did not seem that shorting treasuries was a "no-brainer" because we all know that the crisis would unleash many more months of pain.

Treasury securities sky-rocketed when there was a flight to quality

The rising prices in risky world assets is a signal that risk-appetite has returned and fear has subsided. Now is the time to assess what that means going forward. The harsh reality is that the United States has a massive amount of debt and is currently paying very low interest rates for that privilege. It is my opinion that will change, and it might even occur very rapidly if consumer demand picks up and inflation scares spike. Betting that interest rates will increase can be done very easily by shorting treasuries (TLT or Bond futures) or by buying put options on those same underlyings. I am not going to make that bet outright, instead I am going to take a more agnostic view and just make some bets on where interest rates should not go. It is helpful to look at where yields were and what that meant for the price of the instrument I want to use to facilitate this bet.

Long rates hit 2.5% at the low and now hover well above 4%

Now that we have both the yield and price charts, we can make some statements regarding the relationship. At a yield of about 4% the TLT (20+ year treasury ETF) traded at about 100 and at 3.5% TLT traded at about 106. I believe that both of these levels provide good barriers to sell call options on TLT.

When I sell options I generally look at selling options that are 3-6 months out. I find that a longer option gives you more breathing room so that you do not get stopped out of the position. When selling very short options you get fantastic time decay (theta) but small changes in price can stop you out of a position more quickly. This would lead me to recommend looking at March or June 2010 contracts.

100 and 105 strikes trade for 2.25 and 1.20 respectively

If you sell these call options at the ask price, then you receive $2.25 for the $100 strike or $1.20 for the $105 strike. This will pay you $225 or $120 per option sold as long as rates do not go lower than 4% or 3.5% by June of 2010. I think this is a high probability trade. If you want to make this more aggressive then you can look at selling the calls and buying put options. That way the purchase of the puts would be partially paid for by the written calls.

I like this trade because it makes good economic sense and because it provides protection against a rising interest rate environment. Remember that rising interest rates are generally bad for equities and very bad for fixed income investments, so you can view this as a partial hedge against your other fixed income assets. The risk is that interest rates plummet as there is another flight to quality. In that case all assets besides treasuries are declining and we probably have more important things to worry about.

Disclosure: Short TLT

Comments

[sgt.red.blue.red]

I’ve got a couple of commercial real estate loans. Both are adjustable interest rate loans. I elected to go with adjustable rate loans for several reasons; 1) where we were in the interest rate/business cycle when I put the loans in place, 2) in that the spreads over the underlying indices, in the case of the Treasury adjusted loans, were the same spread no matter the maturity of the underlying index ), and, as such, 3) most of the time during the interest rate cycle there is a positive yield curve, not a negative one, tipped the scales in favor of the adjustable.

I have 2 loans;

The first loan adjusts annually with one year U.S Treasury (adjusted for constant maturity) index. Index available on H.15, in IBD or WSJ (Tuesday). 1 year UST + 2.625%. So every year, this adjusts.

The second loan adjusts with prime (prime + zero) as change in prime changes (instantaneous).

I would like to know BEST way to hedge against rate increases, $ for $, for each of these loans (short side ETF’s, options, LEAP’s, futures. etc.). In that they are not large loans, the scalability of the hedge (frictional cost) must be considered.

I don’t have any real fear on these things jumping, as I am in the money on both loans now. However, if I can find the optimal “hedging” instrument (e.g. a 3x short ETF), it would be money in the bank.

2009 Nov 01 09:47 PM

[Surly Trader]

<img class="authors_reply" src="static.seekingalpha.co...">

Futures are generally the most efficient way to hedge. When you buy or sell a leverage ETF they are often using futures as part of their investment program. You do not have a perfect hedging vehicle for your situation available. Two year treasury futures would be the closest match to your 1 year UST exposure (TUZ9). Euro$ futures are probably your best way to hedge your prime (typically fed funds +3%). Basically you need to figure out how much the value of your loans increase against you for every basis point increase in rates, then short the appropriate number of Euro$ and two year futures. The problem is that you end up with a liquidity issue because the futures are mark to market and your loan is not. Plus you technically need to hedge each cash flow in the future, so you should be using a string of Euro$ futures, but that's probably not practical for you.

On the flip side, if your loans are very small then it might make more sense to use ETF's such as the barclays short treasury (SHV) or 1-3YR treasury bond (SHY)


On Nov 01 09:47 PM sgt.red.blue.red wrote:

> I’ve got a couple of commercial real estate loans. Both are adjustable
> interest rate loans. I elected to go with adjustable rate loans
> for several reasons; 1) where we were in the interest rate/business
> cycle when I put the loans in place, 2) in that the spreads over
> the underlying indices, in the case of the Treasury adjusted loans,
> were the same spread no matter the maturity of the underlying index
> ), and, as such, 3) most of the time during the interest rate cycle
> there is a positive yield curve, not a negative one, tipped the scales
> in favor of the adjustable.
>
> I have 2 loans;
>
> The first loan adjusts annually with one year U.S Treasury (adjusted
> for constant maturity) index. Index available on H.15, in IBD or
> WSJ (Tuesday). 1 year UST + 2.625%. So every year, this adjusts.
>
>
> The second loan adjusts with prime (prime + zero) as change in prime
> changes (instantaneous).
>
> I would like to know BEST way to hedge against rate increases, $
> for $, for each of these loans (short side ETF’s, options, LEAP’s,
> futures. etc.). In that they are not large loans, the scalability
> of the hedge (frictional cost) must be considered.
>
> I don’t have any real fear on these things jumping, as I am in the
> money on both loans now. However, if I can find the optimal “hedging”
> instrument (e.g. a 3x short ETF), it would be money in the bank.
>
>

2009 Nov 02 09:14 AM

[sgt.red.blue.red]

Thanks, ST. Will review.


On Nov 02 09:14 AM Surly Trader wrote:

> <img class="authors_reply" src="static.seekingalpha.co...">
>
>
> Futures are generally the most efficient way to hedge. When you buy
> or sell a leverage ETF they are often using futures as part of their
> investment program. You do not have a perfect hedging vehicle for
> your situation available. Two year treasury futures would be the
> closest match to your 1 year UST exposure (TUZ9). Euro$ futures are
> probably your best way to hedge your prime (typically fed funds +3%).
> Basically you need to figure out how much the value of your loans
> increase against you for every basis point increase in rates, then
> short the appropriate number of Euro$ and two year futures. The problem
> is that you end up with a liquidity issue because the futures are
> mark to market and your loan is not. Plus you technically need to
> hedge each cash flow in the future, so you should be using a string
> of Euro$ futures, but that's probably not practical for you.
>
> On the flip side, if your loans are very small then it might make
> more sense to use ETF's such as the barclays short treasury (SHV)
> or 1-3YR treasury bond (SHY)

2009 Nov 02 07:14 PM