By Rom Badilla
Most people believe Treasury yields are too low to be attractive. However, most people are clueless around how bond traders make money. Our research below will show you below how to generate 35% return over the next month owning Treasuries.
For our sample analysis, we will use the most volatile and highest leveraged bond just to illustrate our example. The longest outstanding Strip is the U.S. Treasury 0% Coupon, Maturing February 15, 2042 (CUSIP 912803DV2) which has a duration of 29.6 Years.
Strips are securities created by the U.S. Treasury where they separate the principal and interest component of the future cash flows. As a result these high quality securities also known as Zeros which are free of default risk, have no interest payment and are at a significant discount since principal is returned at par at maturity. Due to these characteristics, the duration is higher than its coupon paying counterpart.
To implement, first choose a trading broker that offers bonds as part of its online product platform. We go with Trade Monster’s Bond Trading Center since it is the most robust and covers U.S. Treasury Strips as well as various other fixed income securities such as U.S. Governments, Corporates, and Municipals. More importantly and since our time horizon is short and liquidity is a priority, Trade Monster offers the most transparent markets for bonds with the tightest Bid to Offer spread. So buying and selling with minimal costs is available that is on par with institutional-level trading execution.
Given that we are expecting yields to decline which will push bond prices higher, we set our expected return. Going back to the aforementioned security, the U.S. Treasury Strip (CUSIP 912803DV2) which has a 0% Coupon and Matures in February 15, 2042 is currently trading at a yield of 2.77% at a dollar price of $44.32. If we expect rates to decline 12 basis points to 2.65%, the price of the Strip will be $45.90 for a percentage gain of 3.5% according to the Trade Monster’s Bond Calculator.
Assuming a 30 day horizon, if yields fall just a basis point or 0.01% in yield terms, you will make $296 from an investment of $100,000.
In addition, an investor can use margin as an additional tool to enhance and amplify returns. By using margin, an investor essentially increases their purchasing power by borrowing funds to purchase more of a return-producing asset. In essence it is an efficient use of capital as an investor spots opportunity in the market for a high probability of return and attempts to amplify it by owning as much of it as possible. It’s analogous to a baseball player swinging for the fences when he knows that on a full count, a predictable fast ball will be thrown right down the middle of the plate where he can swing hard without fear of missing.
With Trade Monster, an investor can own up to 10 times the amount of Treasuries for each amount of initial capital. So an investor can own $100,000 of U.S. Treasuries for posting only $10,000 of funds.
So in the case of our example, an investor who used a U.S.Treasury Strip that captured 3.50% gain, would increase their return to 35% using Trade Monster’s margin process.
As with anything, there are costs that an investor should be mindful of when using margin. To have that exposure, an investor is borrowing funds to purchase more assets. In the case of Trade Monster’s platform, the borrowing costs varies according to debit balance. These costs need to be considered in accordance with their time horizon on the trade. Furthermore, margin can lead to larger risk so implementing risk management techniques coupled with strict investing discipline should be used to limit your downside. Exit strategies such as Stop-Loss Orders and Price Targets can go along way in both protecting capital and making money.
So the lesson of the day is that professional bond traders have many ways to generate large returns by trading and using leverage. The old fallacy of buying and just holding to maturity is simply a fools game.
Disclaimer: The above content is provided for educational and informational purposes only, does not constitute a recommendation to enter in any securities transactions or to engage in any of the investment strategies presented in such content, and does not represent the opinions of Bondsquawk or its employees.