S&P Downgrades US Debt to AA+
S&P's downgrade of US Debt to AA+ on Friday night wasn't wholly unexpected. S&P had put the US on watch for a ratings downgrade last month (as did Moody's (MCO)). It also wasn't the first nationally recognized statistical rating organization (NRSRO) to do so: Egan-Jones downgraded US debt in July.
Does a Downgrade Necessarily Mean Higher Yields?
Not necessarily. Jack Ablin, chief investment officer of Harris Private Bank, told The Financial Times on Friday,
I believe it will have little market impact near-term. There’s a global glut of savings with few safe havens. The US, Japan and Italy are the three most liquid sovereign bond markets. Which would you want?
It's worth noting, too, that despite Japan's AA sovereign debt rating, its borrowing costs have been lower than those of the US: On Friday, the yield on Japan's 10 year government bonds was 1.01%, versus 2.56% for 10 year US Treasury bonds. Granted, there are some key differences between Japan and the US. For example, nearly all of Japan's sovereign debt is held by Japanese households and institutions, while only about half of US public debt is held by Americans.
Hedging Against a Rise in Treasury Bond Yields
If Treasury bond yields rise, then Treasury bond prices will fall. Below is an example of how an investor could hedge against a drop in Treasury bond prices using optimal puts on iShares Barclays 20+ Year Treasury Bond ETF (TLT) as a proxy for it. First, though, a quick note about volatility, and a reminder about what optimal puts mean in this context.
Higher Volatility Means Higher Hedging Costs
Generally, higher volatility means higher hedging costs, so it's important to note that the Chicago Board Options Exchange Market Volatility Index (VIX) closed at its highest levels of the year Friday, at 32. All things equal, it's better to hedge when volatility is relatively low, and hedging costs are lower. Nevertheless, although the VIX closed at its high for the year on Friday, its 5-year chart shows that this is still considerably lower than the levels it hit during last year's Flash Crash and the aftermath of the Lehman collapse in 2008.
About Optimal Puts
Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. As University of Maine finance professor Dr. Robert Strong, CFA has noted, picking the most economical puts can be a complicated task. With Portfolio Armor (also available as an Apple iOS app), you just enter the symbol of the stock or ETF you're looking to hedge, the number of shares you own, and the maximum decline you're willing to risk (your threshold). Then the app uses an algorithm developed by a finance Ph.D to sort through and analyze all of the available puts for your position, scanning for the optimal ones.
A Step by Step Example of Hedging Treasury Bonds, Using TLT as a Proxy
Step 1: Enter a ticker symbol
In this case, we're using TLT as a proxy, so we've entered it in the "Ticker Symbol" field in the screen cap below.
click on images to enlarge
Step 2: Enter a number of shares
For the purposes of this example, let's assume our investor has $250,000 in Treasury bonds. Since he's got $250,000 in Treasury bonds, and we're using TLT as a proxy, the number of shares we'll enter will be $250,000 / the most recent share price of TLT ($102.32, as of Friday's close) = 2,443.3. We've rounded that down to 2,443 and entered that number in the "Shares Owned" field in the screen cap below.
Step 3: Enter a decline threshold
You can enter any percentage you like for a threshold when using Portfolio Armor (the higher the percentage though, the greater the chance you will find optimal puts for your position). The idea for a 20% threshold comes, as I've mentioned before, from a comment fund manager John Hussman made in a market commentary in October 2008:
An intolerable loss, in my view, is one that requires a heroic recovery simply to break even … a short-term loss of 20%, particularly after the market has become severely depressed, should not be at all intolerable to long-term investors because such losses are generally reversed in the first few months of an advance (or even a powerful bear market rally).
Essentially, 20% is a large enough threshold that it reduces the cost of hedging but not so large that it precludes a recovery. So we've entered 20% in the Threshold field in the screen cap below.
Step 4: Click the red button
A moment after clicking the red button, you'd see the screen cap below, which shows the optimal put option contracts to buy to hedge against a >20% drop in TLT between now and March 16, 2012. The cost of this protection on a $1 million position would be $3,024, or about 1.21% of the position value.
Two notes about these optimal put options and their cost:
- Portfolio Armor rounded down the number of shares of TLT we entered to the nearest hundred (since one put option contract represents the right to sell one hundred shares of the underlying security), and then presented us with 24 of the put option contracts that would slightly over-hedge the 2400 shares of TLT they cover, so that the total value of the 2443 shares of TLT would be protected against a greater-than-20% decline.
- To be conservative, Portfolio Armor calculated the cost based on the ask price of the optimal puts. In practice an investor can often purchase puts for a lower price, i.e., some price between the bid and the ask.
Disclosure: I am long puts on TLT as a hedge.
