Bond King Bill Gross Warns Of 'A Supernova That Will Explode'

| About: iShares 20+ (TLT)
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Treasuries have trounced stocks year-to-date, with TLT nearly tripling the return of SPY.

As TLT flirted with an all-time high last week, bond king Bill Gross warned low rates were a "supernova" that would explode one day.

We present a low-cost way of hedging TLT in case of a supernova, or a less-astronomical setback over the next several months.

Treasuries Trounce Stocks

On StockTwits late last week, trader Jackdamn shared the chart below, showing how the iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT) had nearly tripled the performance of the SPDR S&P 500 ETF (NYSEARCA:SPY) year-to-date.

Screen capture via StockTwits

Not only has TLT been outpacing SPY, but, as StockTwits user Greenport highlighted with the chart below, it's approaching an all-time high.

Screen capture via StockTwits

Trouble Ahead?

As TLT flirted its high on Thursday, Bill Gross, the long-time PIMCO bond manager now at Janus Capital, raised a warning about low rates globally in the tweet below shared by Janus.

Bloomberg elaborated on Gross's warning after his firm shared that tweet:

A supernova is a star at the end of its life that suddenly increases greatly in brightness because of a catastrophic explosion that ejects most of its mass.

Gross has argued for some time that the economy is at the end of a decades-long cycle of expanding credit that has culminated in negative interest rates, a situation he said is unsustainable. Rather than spurring economic growth, low rates are promoting asset bubbles as investors reach for higher yields while punishing individual savers and industries that rely on interest rates, such as bank and insurance companies, according to Gross.

Supernova Insurance For TLT

Gross isn't the first bond maven to warn about a bubble. Alan Greenspan warned about a bond bubble last August. If you got out of TLT when you heard his warning, you would have missed out on a gain of about 5.3% over the next 6 months. There are two problems with warnings like those by Greenspan last August and Gross now:

  1. If you sell, and the bubble doesn't burst over the next several months, you may miss out on gains over that time period.
  2. If you don't sell, and the bubble does burst, you may suffer steep losses.

The third option (no pun intended), is to stay long and hedge (for a refresher on hedging terms, please see the section titled "Refresher On Hedging Terms" here). Last August, we posted an optimal put hedge for TLT, mainly because optimal collar hedges for it then weren't attractive: they capped potential upside without significantly lowering hedging cost. That's not the case today, so we'll present an optimal collar hedge below.

We used Portfolio Armor's iOS app to find the optimal collar to hedge TLT, but you don't need the app for that. You can find optimal puts and collars yourself by using the process we outlined in this article if you're willing to do the math.

Recall that when scanning for an optimal collar, you need to determine the largest drawdown you're willing to risk (your "threshold", in our terminology). We've used a threshold of 10% in the example. You could use a smaller threshold if you're more risk averse, but, all else equal, that will be more expensive.

In addition to your threshold, you'll also need another figure, your "cap," which refers to the maximum upside you are willing to limit yourself to if the underlying security appreciates significantly. A starting point for the cap is your estimate of how the security will perform over the time period of the hedge. You don't think the security is going to do better than that anyway, so you're willing to sell someone else the right to call it away if it does better than that.

Since the Portfolio Armor website calculated a potential return of 8% for TLT over the next 6 months, we used that as the cap for our collar.

This was the optimal collar, as of Friday's close, to hedge 400 shares of ABX against a greater than 10% drop by mid-December, while not capping an investor's upside at less than 8% by then.

As you can see above, the cost of the put leg of this collar was $572, or 1.06% of position value. But as you can see below, the income generated from selling the call leg was $644, or 1.19% of position value.

So the net cost of this collar was negative, meaning an investor would have collected $72 when opening this hedge. A few notes about this hedge:

  • To be conservative, the cost of the optimal collar was calculated using the ask price of the puts and the bid price of the calls. In practice, an investor can often buy puts for less and sell calls for more (again, at some price between the bid and the ask), so in reality, an investor would likely have collected more than $72 when opening this hedge.
  • Due to time value, this hedge may provide more protection than promised if the underlying security declines in the near future (for an example of this, see this recent article on hedging Apple). However, if the underlying security spikes in the near future, time value can have the opposite effect, making it costly to exit the position early (for an example of this, see this article on hedging Facebook) - Facebook Rewards Cautious Investors Less).

Disclosure: I/we 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.