ETF Ideas

Includes: LQD, PHB, TBT, USO
by: Chris Fernandez

The recent turmoil and volatility has presented us with a ton of great ways to play the market, interest rates, oil prices and an economic turnaround both in the U.S. and abroad.

In this post I want to go over a few ETF’s (Exchange Traded Funds), in particular, one directly dealing with interest rates and treasuries, and one dealing with the price of oil, and finish off the post with a quick roundup of some other ETF’s poised to provide stellar returns for corporate and commercial bonds.

They might not be sexy names, or even names that you’ve heard of before, but they offer a way to diversify your holdings and take advantage of an unprecedented time in our history.

While not formal recommendations yet, these ETF’s represent great ways to diversify your holdings, take on risk intelligently and in a calculated way, and do something different with your money that doesn’t involve investing in just stocks.

In addition, ETF’s offer a great way for you to buy into themes (rising/falling commodity prices, interest rates, etc.), and industries that you otherwise would have no business investing in, or would have no access to in the first place.

So what do I got for ya? Here we go…

A Word of Caution

I will warn you, what I am about to show you and talk about is not for the faint of heart, timid, or for money that you cannot afford to lose.

Unlike the other investments that I talk about and recommend on my site, these don’t have any “fundamentals” or management to vet, balance sheets to look at, or other similar things that we can use to gauge risk, and give us an edge over Wall Street.

If you decide to play any of the ETF’s that I am writing about today, you do so at your own peril.

Remember that ETF’s represent a basket of securities, commodities, bonds, etc., and are usually never tied to any one company, or product, aside from ones like the oil fund, that specifically play on one theme.

As such, these funds move at the whims of the market, and can turn on a dime in either direction.

They are emotional and momentum based vehicles useful for playing panic in either direction.

Be wise, use tight stops, and tread lightly if you cannot afford to lose that money.

Let’s Talk Treasuries!

We’ve all been hearing about lower interest rates for home loans and that the U.S. government stepping in to take those loan rates down to as low as 4.5% for non-conforming loans.

What some out there might not realize, is that in the mean time, U.S. treasury yields have fallen precipitously, so much so, that the yield on a 3-month Treasury bill actually turned NEGATIVE for a time a few weeks back and sits precariously close to 0%.

You read that right: People are buying U.S. debt for little to no return, in fact even PAYING for a negative return, just to find some safety for their money and investments.

Would you say that that’s a little overdone and silly?

Yea, I say the same thing.

At the same time, yields on other U.S. treasuries like the 10-year and the 30-year notes have fallen just as much, and now sit at ridiculously low levels.

In fact just last week, there was a great article by Barrons outlining how the U.S. Treasury market is now the next “bubble” to pop, and is poised to come crashing down to Earth, and in turn, yields are poised to rise.

You see, the U.S. treasuries work inverse in that when the price goes up, the yield goes down, and visa versa.

So, with the craziness with U.S. equities that has been taking place over the last 12 months or so as a result of the financial crisis, consumer slowdown, commodity price swings, etc., there has been a serious flight to “quality”.

I use the term quality lightly because the way I see it, how high in quality is an investment instrument that you are literally paying for that yields negative returns that is supposed to be rock solid and safe and traditionally yield very steady and decent returns?

Is it better than losing 40% in the market over the last year? Sure I guess, but the way things have gone now, these traditional “slow-moving” investments and safe havens have become rich, and in turn look poised to tumble as yields and interest rates rise over time.

From the Barrons article:

The chief risk to the Treasury market stems from the potentially inflationary impact of both the Federal Reserve’s super-accommodative monetary policy, which has dropped short rates close to zero, and the enormous looming fiscal stimulus from the federal government. It also may take higher yields to attract investors — particularly foreigners — as the Treasury seeks to fund an estimated deficit of $1 trillion or more in the coming year.

So how do we play this theme then?

Well, traditionally, most investors can’t sell Treasuries short, but through the intelligent purchase of an ETF called the Ultrashort Lehman 20+Year Treasury Proshares (NYSE: TBT) you can in essence short treasuries.

Be careful though, this ETF moves at twice the inverse of the daily price movement in Treasury notes and bonds, and therefore is way more volatile than a straight bond fund.

However, with this leverage, it is possible to make 100% return with just a 50% move in Treasury prices to the downside.

Since the summer, the 20+Year Proshares has fallen almost 50% as Treasury prices have surged.

If Treasury yields return to June 2008 levels, the ETF could double in price, which is not entirely inconceivable.

Let’s Talk Oil!

Oil is another theme that plays out before our eyes on a daily basis.

Prices rose to as high as about $150 per barrel during the peak, and are now around $40 or so a barrel.

It’s obvious to anyone that watches these dramatic price swings that there is potentially a lot of money to be made playing those swings by traders.

I had my friend Jonathan Keim of send me a technical analysis look at the U.S. Oil Fund ETF (NYSE: USO), because I felt that it was a great way to play short term movements in the price of oil.

You can click on the thumbnail below to open Jonathan’s analysis of this ETF.

USO TechnicalAnalysis 1-10-09

We all know that short term spikes in the price of oil, similar to what we had in the last week or so before prices fell again, due to anything from political turmoil, consumer demand, or any other perception of what might or might not happen, are as common as the rising of the sun.

When prices soared to $150 per barrel, they probably overshot. Similarly, now that prices are below $40, and apparently headed lower, they also might be going too low.

So, that being said, I wanted to present a way that you could play the price of oil on a 1-1 basis (in other words, this ETF is not leveraged like the one above for Treasuries was), and the USO is a simple and clean way to do that.

According to Jonathan, it looks like we are getting close to certain resistance levels where oil might make a short term bounce, and by short term I mean it could be 1-2 days, or 1-2 weeks.

Longer term, it looks like oil might be bottoming, but you never know that until it has already taken place, thus the risk.

Support levels to the downside appear at $33.00 and $27.70.

Since USO closed today at about $30, it looks like we’ll be testing the $27.70 level here shortly.

If you do go long this ETF, make sure you use a nice tight stop limit below the lowest support level on this chart, and protect yourself from potential losses.

If USO bounced from here, as Jonathan noted, it will be up to you to decide at what price you want to sell.

A trailing stop might be a nice way to play your uncertainty surrounding when to sell.

Playing the High Yield “Junk” Bond Market

I won’t profess to be an expert in any of these areas that I have outlined today, but when such obvious themes are staring us in the face, you owe it to yourself as a diversified investor always seeking the best possible returns, to look into something that perhaps is not your strong suit, and learn about it.

Such is the case for the corporate high yield bond market.

From what I understand, these entities are being priced at levels last seen during the great depression.

In other words, traders aren’t buying debt from companies because they are afraid those companies might very well go out of business sooner than later leaving them with the debt.

As such, traders have demanded a much higher return on their investment, and a much higher premium to U.S. bonds and Treasuries.

You can see this taking effect when you look at the current yields offered by some of these bond funds that invest in corporate debt.

They are paying astronomically high returns. In other words, companies now have to pay higher rates of return as if they were all going to go out of business, and traders are demanding as much.

So, we get to benefit by investing in ETF’s that invest in these instruments.

Besides the potential for return, the nice thing with these ETF’s is the yield payments that are paid quarterly, and since you own the ETF interest is distributed as a dividend and therefore taxed at 15% instead of an interest payment of a direct bond ownership.

So what are some names in this space? I’ll list them below from least risky, to highest risk/highest return.

  • iShares iBoxx Invest Grade Corp Bond ETF (NYSE: LQD): Currently yields about 5.55%
  • Vanguard Intermediate-Term Investment-Grade Bond ETF (MUTF:VFICX): Currently yields about 5.86%
  • T. Rowe Price Corporate Income Bond ETF (MUTF:PRPIX): Currently yields about 6.15%
  • Loomis Sayles Bond Retail ETF (MUTF:LSBRX): Currently yields about 9.27%
  • PowerShares High Yield Corporate Bond ETF (NYSE: PHB): Currently yields about 14.58%

As we can see, as the yields go up, so does the risk.

The last one is of course the riskiest, but pays the highest yield as well.

From what I understand, if you invest 10% or so of your money in the last ETF, even if most of the holdings go to 0, and you get $.30 on the dollar, you still break even on the investment, but tread very carefully in these names.

In addition, you should conduct your own due diligence on the companies that comprise these ETF’s as well as what they are investing in, timeframes, etc.

Bottom Line

ETF’s are a wonderful way to play larger themes, or get into investments that you otherwise would have no business investing in, or would not have the means in which to invest in as an individual investor with limited resources.

Used carefully in conjunction with a balanced portfolio, ETF’s offer a great way to play on some of the themes playing out before our eyes, where we know that we can make money, we just might not know how.