ETFZone.com
Fixed Income ETFs: Trading in a Bear Market (Part 2 of 2)
Sunday April 10, 6:46 pm ET
By Jonathan Bernstein, ETFzone Trading Specialist
Although rising rates most likely mean a bear market for bonds, this does not mean there is no money to be made in trading bond portfolios. One idea is to sell short fixed income ETFs (which are portfolios of bonds), with the idea of profiting from their fall. However, because of the continuing domestic and foreign demand for safe investments as well as the high yields fixed income ETFs provide (and a short seller is expected to pay), selling fixed income ETFs short can be both difficult and dangerous. One alternative is to develop a hedged or short-long position in these funds that is neutral in respect to interest rate changes, but makes a bet on credit spreads.
A credit spread is measured in the number of basis points that corporate or non-treasury debt trades above treasury debt. US treasury debt is considered the safest investment in the world. As a result, an investor holding a treasury bond is paid a lower interest rate for holding that bond compared to bonds the market deems more risky, such as bonds issued by corporations. In times of fear, investors seek out the safest investments, and demand for treasuries increases. Investors are willing to pay a premium for owning treasury bonds and demand a higher percentage return for corporate bonds. When this happens, credit spreads widen. On the other hand, when investors become more confident that corporations will repay debt, credit spreads typically narrow.
Many credit spreads have not been so tight since before LTCM (Long Term Capital Management), the hedge-fund run by ex-Salomon Brothers bond trader John Meriwether, nearly brought down the world financial system in 1998 through betting, primarily, that credit spreads would narrow and market liquidity would increase. As the chart below shows, credit spreads have been decreasing since 2000 and are historically tight.
The above chart is the historical credit spread of B-rated industrial debt above treasuries. It has March of every year on the horizontal axis and the number of basis points this debt trades above treasuries on the vertical axis. The chart shows the sharp move upward in the fall of 1998 that ruined LTCM, reflecting the "flight to quality" during the Russian debt crisis. Two years later, in 2000, the even sharper spike reflects investors' move into treasuries as the equity markets collapsed and corporate scandals emerged. Since late 2002 credit spreads have narrowed considerably. B-rated industrial debt now trades about 300 basis points (3%) above treasuries.
How might an ETF investor make a bet on the direction of credit spreads? He could develop a combination of a long and a short bond position. If an investor expected credit spreads to widen he would want to own treasury debt and sell or short corporate debt. If he expected credit spreads to continue to narrow, he would want to make the reverse trade: long corporate debt and short treasuries. The iShares Lehman 20 Year Treasury Bond Fund (AMEX:TLT - News), iShares Lehman 7-10 Year Treasury Bond Fund (AMEX:IEF - News) and the iShares 1-3 Year Treasury Bond Fund (AMEX:SHY - News) are all ETFs with portfolios of treasury bonds. The iShares Goldman Sachs InvestTop Corporate Bond (AMEX:LQD - News) holds corporate bonds exclusively.
In order to make a bet purely on the credit spread, an investor would want to match bond maturity and duration as closely as possible. According to iShares, bonds held in LQD have an average maturity of 10.11 years, and average effective duration of 6.62. Among fixed income ETFs holding treasury bonds the duration and yield profile of IEF, which has an effective duration of 6.44 and average maturity of 7.75 years, is closest to LQD.
The historical credit spread chart above compares the ten-year treasury with high yielding B-industrials. The bonds held in the LQD portfolio, however, are mostly high grade debt, with, on average, A quality. The chart below, though similar to the above chart, shows the credit spread of of the higher grade A quality debt, compared to the benchmark 10-Year treasury.
Like the first chart above, this chart has time on the horizontal axis and basis points that highly rated corporate debt trades above treasuries on the vertical axis. This chart also reflects the "flight to quality" during the Russian debt crisis in 1998. The move up in 2001 reflects investors' move into quality after September 11th. Since September 11th, credit spreads have narrowed considerably. A-rated industrial debt now trades about 60 basis points (0.6%) above treasuries.
One note of caution for any investor who sees an opportunity to be long on treasuries and short on corporate debt: historically, credit spreads have narrowed in environments of rising interest rates. There may be less risk of this now due to the already historically tight credit spreads shown in the charts above.
Using ETFs to make a bet on the direction of credit spreads is somewhat difficult, because the only fixed income ETF focused on corporate debt has a portfolio of high-grade corporate bonds. Making a bet on the direction of credit spreads will become easier with the introduction of an ETF focused on the typically more volatile high-yield bonds. Since eventually there will likely be ETFs offered for every major financial product, it is only a matter of time before using ETFs to make bets on the direction of credit spreads becomes a common strategy.
Jonathan Bernstein has specialized in short-term trading of equities and equity options since 1998.
