We are once again entering interesting times in the credit and equity markets. While large hedge funds and other institutional money managers are in a better position to take advantage of some of the opportunities from dislocations and volatility, the question remains how smaller investors can potentially profit. The answer lies in a long/short trade I am affectionately going to call 'Twist & Shout.' Twist, because the Fed's Operation Twist and market fear will likely flatten the yield curve more than we anticipate (not to mention institutional investors looking for more duration); and Shout, because the guys about to lose money in high yield bonds will be shouting loudly until that market sees its bottom. Ultimately, it is a play on credit spread expansion and yield compression in the credit market.
Twist - Long TLT
The Federal Reserve is attempting to force money into risk assets. Since short-term rates are as low as they can go, they must now focus on the long end of the curve. When yields decrease, the value of bonds increases. Yields on bonds decrease when their prices are "bid up" by buyers seeking to own them. In this case, the buyer is the largest one on the planet - the US Federal Reserve - and the Fed wants to own the bonds pretty badly (i.e. they are willing to pay high prices).
Looking back over the four year period ending June 30th, 2011, we can see the relationship between returns on TLT (y-axis) versus changes in the Yield to Maturity (YTM) on 20 Year Treasuries.
Looking at the returns for TLT versus changes in the YTM on 20-Year Treasuries, we can see that returns are negative when changes in YTM are positive and positive when changes in YTM are negative. In the case of the Fed's Operation Twist, we can expect that changes in YTM will be negative. While the Fed is buying, smaller investors can take advantage of the same opportunity larger institutional investors and hedge funds are taking advantage of. It is important to understand that once the Fed completes its program, there is much less certainty about the direction of yields - but more on that later.
Shout - Short HYG
The high yield bond market, formerly called the "junk bond" market, is the bastion of the sophisticated credit investor. High yield bonds are typically issued by two types of companies: good ones that are too small or untested to access cheaper credit or ones whose credit standing has deteriorated because of leverage or uncertainty that must pay for expensive credit. In either case, the yields in this market can move quickly and are typically directly related to the volatility, or price variation, in the equity market. This is because a company's implied leverage decreases with equity price increases and increases with equity price decreases. Since increased volatility is typically associated with declines, yields on these securities can widen very quickly. A prime example of this occurred in 2008.
Looking back over the four year period ending June 30th, 2011, we can see the relationship between returns on HYG (y-axis) versus changes in the Yield to Maturity (YTM) on a benchmark high yield index.
As with TLT versus the 20 Year Treasury YTM changes, looking at the returns for HYG versus changes in the YTM on high yield bonds, we can see that returns are negative when changes in YTM are positive and positive when changes in YTM are negative. High yield bonds are a little bit different than Treasuries because change in YTM can occur because of changes in interest rates or because of changes in credit spreads (i.e. the premium paid over a reference rate for a company of a given credit quality). It is important to understand that markets are a discounting mechanism and that the dynamics of the high yield market are unique in some regards - but more on that later.
Trade Rationale
The Fed is buying 20-year Treasuries which should make the YTM go down, meaning the price for TLT is likely to increase. Given the crisis in Europe and concerns about the spillover effects, compounded by the economic weakness we are experiencing that is expected to worsen, the YTM on high yield bonds is likely to increase. This is because in environments of higher uncertainty, investors want to earn more money for the risk they are taking than when there is less uncertainty. We can all say that uncertainty abounds today!
The rationale behind this trade is that one wants to take advantage of the expansion in yields in the high yield market and the downward price pressure it creates, while taking advantage of the Fed's appetite for longer duration bonds and the upward price pressure it may create. To do so, you sell or "short" HYG and buy or "long" TLT. By investing an equal dollar amount in both, you will have a neutral trade. Not including transaction costs and market friction effects, this trade earned a total return of 51.1% assuming a 50% initial margin requirement for each position (10 shares short of HYG, 11 shares long of TLT), initiating the trade on 12/31/2007 and closing it on 12/31/2008. Over the same period of time the SPY ETF returned negative 38.28%. That's a difference over 80%!
Trade Risks
An 80% return does not come without risks. Credit markets, especially the high yield market, move very quickly, making and losing investor money along the way. A one basis point move on a 20-Year Treasury can wipe away equity very quickly as well. Inexperienced investors should not pursue this type of trade and experienced investors should understand all the risks. Right now, there are two things working in your favor: the Fed is a buyer with a large appetite and the markets are growing fearful, repricing credit risk along the way. The uncertainty lies in the transition period when the Fed is no longer a buyer if demand drops and investors sell 20-Year Treasuries, and in the relative speed of the repricing of high yield risk. In the case of high yield, once the market perceives improvement, spreads can tighten almost as quickly as they widen. All of the above said, if you watch the market and can stomach the risks, it makes for an interesting trade, in particular at times like this!
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in TLT over the next 72 hours.
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