On Floaters and the Yield Curve

As I expected, the 10-year treasury was very well received. The bid to cover ratio was a string 2.81 versus an average of 2.61 for the last 10 auctions. The indirect bidders (which includes foreign central banks) came in at 47.3% versus a prior 47.4%. The 30-year auction was a bit softer than expected, at least on the surface. The bid to cover ratio for the 30-year government bond slipped to 2.26 from 2.39 average for the last 10 auctions. Foreign central bank buying remained strong.

Last week's auctions caused prices on the long end of the curve to rally, but that did not help the U.S. dollar as investors continue to invest in foreign currencies. I think that bubbles exist in foreign currencies, equities, high yield bonds and some high grade bonds. Joining me in the camp is Bill Gross of PIMCO. Bill believes that those markets are over done and U.S. treasuries are the place to be. It is difficult for me to say this as a long-time corporate bond trader, but the credit markets are overdone here. Spreads between 10-year industrials, such as Wal-Mart (WMT) are well under 100 basis points. Verizon (VZ) and AT&T (T) paper are in the 100 basis point area. Only in the bank and finance arena does some value exist. That is because there could still be some bad news (but not fatal news) ahead. The more retail participation, the more overvalued the asset class at this time. This goes double for floating rate notes.

I have been through the floater story before. I still have financial advisors buying floaters at tight spreads and very low yields in an effort to eliminate interest rate or, in the case of CPI floaters, inflation risk. These products do no such things. If floaters eliminated these risks for investors, they would create such risks for the issuers. Why is it so difficult for advisers and investors to understand this? It irks me when advisers tell me they know better and that I am wrong. Please, I don't tell financial advisers how to do estate planning, don't tell me how bonds work. Bonds have been my specialty for over 20 years.

Libor-based floaters do best when the yield curve is flat and the coupon benchmark (LIBOR) and the trading benchmarks (10-year or 30-year treasuries) are similar. This is why their prices are at discounts even though long-term rates have crept up. Fixed-rated bonds and preferreds have rallied tremendously. Most LIBOR floaters are so far below their floor coupons based on calculations that it is going to take 300 or more basis points of Fed tightening before these securities can move above their floor coupons. By that time we could be into the next part of the economic cycle, heading towards lower inflation and lower long-term rates and the Fed once again easing.

CPI floaters adjust off of the year-over-year change of the rate of inflation based on the CPI Urban Consumer Index (non-seasonally adjusted). If inflation, YoY, is at 3.00% for two consecutive years, your coupon FALLS to its spread over the index. If inflation declines from 3.00% to 2.00%, your coupon drops. The coupon would be spread off of a negative calculation. Anyone buying these for inflation protection should be tested for drugs. Buying floaters is to SPECULATE that the observed benchmark will perform in a certain fashion. LIBOR floaters do best when the curve flattens and CPI floaters do bets when the RATE OF INFLATION rises. TIPs are rich as well, but at least a case can be made to have a hedge versus inflation. The best strategy for rising rates or inflation is to ladder or barbell a portfolio.

Disclosure: No Positions

Comments

[Thomas MacLeod:]

If you are saying that treasuries are the place to be then in essence you are implying that there is no risk of inflation! Perhaps the official stats suggest so but the commodity mkt is suggesting something completely different

Nov 16 04:21 PM

[ilc:]

Hey, what would be a good way for a retail investor to short long-term treasuries?

I don't understand options or floaters. I don't like TBT because it is a 2x ETF with a daily reset. TBF is a little better because at least the daily reset is only on a 1x fund; it gives a nicer inverse to TLT over time. But I still don't love it, because of the daily reset. That's the limit of my knowledge. Is there something better out there? Thanks.

Nov 16 04:47 PM

[Angel Martin:]

With the caveat that I think it is very risky to short treasuries in what, so far, is a disinflationary environment: you could do a synthetic short with options, which would be to write a call and buy a put at the strike closest to the current value of IEF, which is a 7-10 year treasury ETF.

Something simpler, you could buy a deep in the money put of something like IEF. This isn't a true short. For small price movements the price of the option should move point for point with the underlying ETF. But, the % change in the value of the position will be much larger. The highest strike longest dated option for IEF would give you something like a -12X to -14X treasuries ETF, with no rebalancing.

If you have some idea of how much the 10 year treasury will move and when, you could just look at put options directly.

On Nov 16 04:47 PM ilc wrote:

> Hey, what would be a good way for a retail investor to short long-term
> treasuries?
>
> I don't understand options or floaters. I don't like TBT because
> it is a 2x ETF with a daily reset. TBF is a little better because
> at least the daily reset is only on a 1x fund; it gives a nicer inverse
> to TLT over time. But I still don't love it, because of the daily
> reset. That's the limit of my knowledge. Is there something better
> out there? Thanks.

Nov 16 09:12 PM

[Bernard Thomas:]

I am saying ladder, barbell or weight the belly of the curve. I think commodities and foreign currencies are over done. One clue is the amount of retail interest in these areas. That is the kiss of death. When the Fed tightens late in 2010, the house of cards crashes down.


On Nov 16 04:21 PM Thomas MacLeod wrote:

> If you are saying that treasuries are the place to be then in essence
> you are implying that there is no risk of inflation! Perhaps the
> official stats suggest so but the commodity mkt is suggesting something
> completely different

Nov 16 11:38 PM

[Bernard Thomas:]

I think long-dated treasuries will rise modestly throughout the coming economic cycle. fed Funds top out around 4.00%. Don't overweight either end if the curve. Weight both ends or ladder. Short-term rates will rise so gradually that your average yields over the next several years may not equal the yield of the current 10-year note and then short-term yields will fall again.


On Nov 16 04:47 PM ilc wrote:

> Hey, what would be a good way for a retail investor to short long-term
> treasuries?
>
> I don't understand options or floaters. I don't like TBT because
> it is a 2x ETF with a daily reset. TBF is a little better because
> at least the daily reset is only on a 1x fund; it gives a nicer inverse
> to TLT over time. But I still don't love it, because of the daily
> reset. That's the limit of my knowledge. Is there something better
> out there? Thanks.

Nov 16 11:41 PM