A Simple 3-Step Strategy for Trading Bonds

by: Jeffrey Dow Jones

It's been a heck of a ride for bonds. The stock market gets all the credit for being the best buy-and-hold investment of the "Long Boom", but seriously, it's been an arguably greater run for bonds. After almost 30 years of steadily declining interest rates, the bond market is approaching a new frontier. Most of us have never seen this before, at least not during our investing careers (click on images below to enlarge):

That is a lot of capital appreciation in the chart. And as you can see, Treasury yields are now getting down into that range where they literally can't get much lower. I know I'm not the first guy to write about this on the internet, but it's true.

There does exist a possibility that the U.S. will become like Japan, in which case the future of our bond market may very well look like this:

But, who knows? The future could be super inflationary in which case interest rates might trend upwards for a decade. Either way, the long-term upside in bonds is pretty unattractive, and the same can be said for the short run. QE2 is now over. The Fed is done gobbling down Treasuries and expanding its already gigantic balance sheet. (it is levered over 50:1, you know.)

A couple of months ago we wrote about what would happen when QE2 came to a close (see here). For the most part, all of that stuff happened. It was funny, usually my contrarian forecasts turn out spectacularly wrong, which is why I try not to make a business out of challenging the impossible and attempting to predict the future. It is best to always take forward looking statements (from anyone) with a grain of salt.

But this one was oddly prescient, consider the following;

  • Stocks stopped going up, and now seem to be carving out a range.
  • Commodities got clobbered.
  • Interest rates spiked dramatically higher.

In truth, I think the jury is still out on interest rates. As quickly as interest rates rallied, the rates sold back off again. So we'll see. Ultimately, I do believe the fate of the Treasury market comes down to Bill Gross' point about "who will buy them?" There are definitely plenty of people around the world with an appetite for Treasuries, and their demand for Treasuries is pretty inelastic.

Many of these guys are large institutions or sovereigns who have to buy Treasuries and will do so at any price. So it's not like the 10-year is going to 5% overnight or anything. But I just wonder if these guys can support the entire market.

In the meantime, let's put together a strategy that should work regardless of what the long-term future of the market looks like.

Given the current economic environment and the range of U.S. growth forecasts for the next couple of years, I think it's very reasonable to expect that bonds will trade inside a range. We're in the muddle through phase of the recovery and whatever happens, it likely won't shock the bond market by too much, too quickly.

Step One: Define the Range

You can probably refine this a little further, but allow me to suggest that 3% and 4% are good brackets to use.

We know from the last couple of years that it takes a pretty extraordinary and shocking event to get the 10-year yield below 3%. It's happened only three times in recent history.

  • The first was after Lehman Brothers blew up during the financial crisis.
  • The second was last summer when Greece first popped on the radar screen.
  • The third was earlier this summer when it looked like Greece might go poof once again.

A 10-year yield under 3% is really, really low. So this is where you want to think about taking a short position in Treasuries (and perhaps even bonds in general).

As for the upper end of our range, it's going to take another extraordinary event and set of conditions to get the yield above 4%. You see, at no point in history has the 10-year Treasury note ever yielded 4% more than the Fed Funds rate.

So that's as rock solid a spot as you're ever going to find at which to take a long position in Treasuries - at least as long as the Fed has its boot on the neck of short rates. The good news about that is that those moves are telegraphed far in advance and it doesn't look like they'll be doing much any time soon.

If the 10-year yield gets back up in the high 3% or 4%, scoop 'em up!

Step Two: Vehicles to Use

You can certainly buy and short Treasuries in the futures market. That's the way the big boys do it, and these days it isn't very difficult for the investor at home to play them that way. You do have to know what you're doing though, because commodities markets are neither for the inexperienced nor the faint of heart. Make sure you employ the counsel of a pro.

An easier way to play this strategy is with ETFs:

  • On the long side you can use something like the SPDR Barclays Intermediate Term Treasury ETF (NYSEARCA:ITE), which will be a little less risky with an average maturity of just over 4 years, or iShares offers the Barclays 7-10 Year Treasury Bond ETF (NYSEARCA:IEF). Also, you may buy the iShares Barclays 10-20 Year Treasury Bond ETF (NYSEARCA:TLH). If you want some extra zing, you can go out a little further with something like the SPDR Barclays Long Term Treasury ETF (NYSEARCA:TLO), that has an average maturity of over 20 years. And there's always the iShares Barclays 20+ Year Treasury Bond ETF (NYSEARCA:TLT).
  • On the short side it is a little bit more tricky. Direxion offers the (NYSEARCA:TYNS) and (NYSEARCA:TYBS) which attempt to go 1x short the 7-10 year Treasury Index and 20+ year Treasury Index respectively. They also have a 3x short of the 20+ year index, TMV. But, that thing is pretty volatile and as with any leveraged ETF, or short ETF, you have to take a look at how these funds are actually constructed and how well they actually do replicate the underlying index or asset. ProShares offers the (NYSEARCA:TBX) which also shorts the 7-10 year index and the (NYSEARCA:TBT) which is the UltraShort 20+ Year Treasury. That's a pretty big fund and very popular trading product.

Step Three: Season to Taste

You'll definitely want to season this trade to your own personal tastes and risk preferences. If you don't want a lot of volatility, play it from the shorter end of the maturity curve. If you want some more movement, then use longer dated bonds and funds.

Also feel free to tweak your own signal range. I do like using the 10-year yield as a signal since it's such a massive benchmark for so many things. But you could also use a more fundamental signal for when to short Treasuries, like doing it when things are looking really scary and everybody is taking risk off everywhere, Or buy Treasuries when rates have rallied and enthusiasm about the economy is running high.

Basically: zig when others are zagging and zag when others zig.

As you might imagine, the better risk/reward bet right now is to probably to play Treasuries from the short side. Yesterday's yield was 2.89%. At the macro level, things could certainly get worse in Europe, but most of the risk in interest rates is probably to the upside, at least for the time being.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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