Treasuries: If You're Going To Do It, Do It Right

| About: iShares 20+ (TLT)

I want to take this opportunity to applaud fellow Seeking Alpha contributor Macro Economist for having the courage to do what so few would dare to do. In the article, Making A Case For U.S. Treasuries, Macro Economist laid out several potential drivers of higher Treasury bond prices. I would summarize them in the following way: slow economic growth, slowing earnings growth, and relative strength (for Treasuries). Over the years, I've found it to be a very valuable exercise to read opinions contrary to my own. Even if the contrary opinion does nothing to change your own, it can never hurt to challenge your investment thesis. With this in mind, no matter your view on Treasuries, I recommend you take a look at the article and spend some time thinking through its merits.

At today's yields, I would not be a buyer of Treasuries. But that's easy for me to say since I already have a full allocation to Treasuries that I acquired quite some time ago at much higher yields (lower prices). Despite the fact that I wouldn't add to my position at current yields, I think there is merit to the idea that during the next bear market in so-called "risk assets," we could see the 10-year Treasury dip under 1% and the 30-year Treasury touch 2%. In the meantime, I suspect the negative correlation between intermediate- to long-term Treasuries and equities will hold for the foreseeable future. I also think the odds will favor, for some time to come, Treasuries' acting as a compelling way to express a short position in equities.

Of course, when the fiscal cliff and debt ceiling debates arrive over the coming months, there will be a lot of talk about future downgrades of U.S. debt being bearish for Treasuries. As I explain in my book, "The 5 Fundamentals of Building a Retirement Portfolio," the great irony of U.S. debt downgrades is that for certain reasons related to the role that Treasuries play as collateral in the world's financial markets, a debt downgrade can actually be bullish for U.S. Treasuries. This is something I recommend readers research further prior to the upcoming debt ceiling debate. If you would like to read more details about this topic, please consult Chapter 6 of my aforementioned book.

Now back to Macro Economist's article. While I think the article is good food for thought, I would like to caution readers about one aspect of it: the recommendation to buy the iShares Barclays 20+ Year Treasury Bond Fund (NYSEARCA:TLT). If you agree that Treasuries are an investment or trade worth making, I think you should do it right. While I would consider buying TLT after a large rally in the long-bond's yield (drop in price), at today's levels, I think buying TLT or IEF (7-10 year Treasury ETF) involves taking on unnecessary excess risk. Rather than taking on the risk of purchasing Treasury ETFs that might never return to their current prices (if yields move higher), it makes more sense to purchase individual Treasury securities that will mature at par (assuming no default).

There are two arguments an investor typically encounters when debating someone on the merits of purchasing individual bonds versus bond funds. Those arguments are (1) that liquidity is a concern with individual bonds and (2) that the cost of building a diversified individual bond portfolio is simply too high. While these arguments may hold a lot of water in the corporate and municipal bond worlds, when it comes to Treasuries, investors can ignore them.

Treasuries are known as the most liquid investment in the world. When you purchase individual Treasury securities, spreads are narrow, liquidity is abundant, and, nowadays, commissions have even dropped to $0 (cheaper than buying the ETF). You may be tempted to argue that liquidity could one day dry up in individual Treasury securities, to which I would respond: If liquidity in the securities underlying TLT (or other Treasury funds) dries up, then liquidity in TLT will dry up as well. Regarding the idea that one could not build a portfolio as diversified as an ETF, when it comes to Treasuries, I don't think it matters. Just pick one Treasury CUSIP with a duration similar to that of the ETF's. While TLT may have multiple CUSIPs underlying the fund, the issuer is the same for the underlying securities, and the durations are all very similar. Choose one, and buy it instead of TLT.

As I further think through some of the potential arguments against buying an individual Treasury over TLT, an additional one (besides the ones outlined above) might be that with TLT, investors could sell covered calls against the position. While I generally don't find the call premiums on TLT to be all that impressive, there may be some investors for whom writing covered calls is simply a must. For those investors, I offer two alternatives, which could be paired with a position in an individual Treasury bond.

First, if you have the option trading authority to write naked calls, you could write a "naked" call on TLT and simultaneously buy a much further out-of-the-money call to limit your margin requirement on the position. I put the word naked in parentheses for the following reason: Even though your broker may view calls you write on TLT as being uncovered (naked), if you own an individual Treasury in the same portfolio, you essentially have the position covered.

Second, if you do not have the option trading authority to write naked calls, the other possibility is to sell puts against the ProShares UltraShort 20+ Year Treasury (NYSEARCA:TBT). By selling puts against TBT, you are agreeing to get long TBT (hence short Treasuries) at a strike price of your choosing. For taking the risk of being assigned shares of TBT, you are paid a premium. Think of this premium in the same way you would the premium on a call option for TLT. If you sold a call on TLT, you would also be agreeing to get short Treasuries (or sell your long Treasury position) and be paid a premium for that. Essentially, you've built the same position by getting long an individual Treasury bond and short TBT puts as you would have with a long TLT and short TLT calls position.

If you like the idea of selling puts on TBT, it is important to understand this quote from regarding TBT:

"This Short ProShares ETF seeks a return that is -2x the return of an index or other benchmark (target) for a single day, as measured from one NAV calculation to the next. Due to the compounding of daily returns, ProShares' returns over periods other than one day will likely differ in amount and possibly direction from the target return for the same period. These effects may be more pronounced in funds with larger or inverse multiples and in funds with volatile benchmarks."

To summarize the quote, when trading TBT, which is a leveraged inverse ETF, be sure to remember that it is designed to track the inverse price performance of long-term Treasury bonds by twice their daily returns. Over time, this ETF will suffer from something known as slippage. For more details on this topic, see ProShares' "The Universal Effects of Compounding and Geared Funds." As a result of the slippage that will befall TBT over time, if you choose to sell puts on that ETF, be sure you stick with expiration dates that are only one to three months forward in time. Also, when choosing your strike price, remember to account for the fact that TBT is a leveraged ETF versus the likely unleveraged long Treasury position you would own.

If I still haven't convinced the Treasury bull that purchasing individual Treasuries would be a better option than purchasing a Treasury ETF such as TLT or IEF, I will further make the case by explaining the benefits a steep yield curve has on individual Treasury securities. If you invest in a fund holding Treasury securities, that fund will hold securities that meet the investment objectives of the fund. If the fund is structured to hold securities with seven to ten years to maturity, for example, the fund will sell the securities around the time they reach seven years to maturity and roll the proceeds into new securities that fit the investment profile of the fund. This means the Treasury ETF investor's position will maintain a relatively constant duration and never be able to fully recognize the benefits of an ultra-steep yield curve. On the other hand, an investor purchasing an individual Treasury security will be able to take advantage of a steep yield curve in a way that Treasury ETF investors will not. Let me provide an example:

Currently, the 11/15/2021 maturing U.S. Treasury note, CUSIP 912828RR3, is yielding 1.594%. The 11/15/2018 maturing U.S. Treasury note, CUSIP 912828JR2, is yielding 0.951%. If you purchase the nine year Treasury today and hold it for three years, assuming no change in the steepness of the yield curve or in yields, that Treasury will become a six year note, yielding 0.951%.

In other words, three years from now, you will not care about what the nine year Treasury is yielding. You will instead care about what the six year Treasury is yielding. Moreover, you will benefit from your original nine year note having dropped in yield by 64.3 basis points (1.594% to 0.951%). This is because your bond will have ridden the yield curve for three years. By riding the yield curve, you will have realized either capital appreciation on top of the interest payments or hedged your position by 64.3 basis points should yields rise. Additionally, the seven to ten year Treasury fund will have dumped that Treasury security long before it turns into a six year note, which means the fund will not have the opportunity to ride the yield curve to the same extent the individual bond holder does.

Naturally, the shape of the yield curve could change over time, and the long-end of the curve will not benefit to the same extent from riding the yield curve as short- and intermediate-term Treasuries will. But I hope my example illustrates yet another benefit of holding individual Treasuries over Treasury funds.

On a closing note, while it may be tempting to attempt to ride the yield curve in corporate bonds (NYSEARCA:JNK) remember that corporates (NYSEARCA:LQD) trade at a spread to Treasuries. Any benefit you get from riding the yield curve could be offset by a rise in corporate spreads. The purest way to ride the yield curve is to do so in Treasuries. And that is yet another reason to favor individual Treasury securities over funds such as TLT. Again, while I wouldn't add to my Treasuries position at today's yields, if you are going to do it, be sure to do it right.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long numerous individual bonds, including Treasuries, investment grade corporates, and non-investment grade corporates.

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