One the macro front, we talk about bonds quite a bit, even though most of our followers are interested in equities and options. We give bonds a good bit of our time as the global debt markets are many, many time larger than the equity markets. One only has to look back to 2008 to understand the beat down in equities was caused by excesses and stupidity in the debt markets. With defaults running at full steam, there was no safe place to hide.
Everyone on the planet, with the exception of central bankers, knows that the bond market is overvalued. Indeed, it was the express intention of the central banks to drive down interest rates (drive up bond prices) in attempt to save the banking system.
We have been bearish or neutral on bonds for the past year depending on the price of long-term debt. As time moves on, however, we become more and more bearish the bond market. Inflation is inching up, debt levels are piling up, the global economy is doing better and fiscal stimulus is on the way. As monetary stimulus hands off the baton to fiscal stimulus, the only direction we see for interest rates is up.
There are a few indicators we think investors need to pay attention to as they navigate the equity and bond markets. The Producer Price Index (PPI) is inching up and it is just a matter of time before investors pay attention and begin to dump their bond holding before interest rates rise. We think a year-over-year increase in the PPI of 3.1% is too high. What has us particularly concerned, is the direction. The momentum is for this measure of the inflation rate to continue to move higher. Who wants to hold bonds paying 2.5% when the inflation rate is 3% and rising?
On the risk front, high yield bonds are massively underperforming equities. This should not be surprising when (1) interest rates are at or near historic lows. There is little or perhaps no capital gains left due to falling interest rates. (2) High yield bonds are equities in drag. They have similar risk characteristics of a buy-write strategy. Investors have limited upside potential and full downside risk. As equities continue to rally to ever higher valuations, the high yield bond investors see their returns called away and all they get is some coupon income.
We are in a very interesting environment. For more than a year now, the chart above shows that high yield bonds as represented by HYG, a high yield bond ETF, has gone nowhere, while equities, as measured by the S&P 50o, have powered higher.
With the technical picture for TLT looking suspect, we have found a fundamental reason to sell bonds. It no longer makes sense for European investors to buy US Treasuries and hedge the currency risk. Doing so now results in a negative yield and if held long enough, a guaranteed loss.
We continue to believe that selling call spread and/or buying long-term puts on TLT is a promising way to position your portfolio for higher rates. We had a call-spread risk-reversal roll off last Friday and for those who did not roll it to a new one, we think it is prudent to consider doing so. With TLT Trading at $125.53, consider the following structure.
To initiate this trade, the investor will pay $109 up front. This structure is a low-cost way of creating a synthetic put option on TLT. As a tradeoff for the low upfront premium TLT has to move a distance to break even, $121.91 in this case. If you were to simply by the $125 strike put, you would have to pay $3.85 upfront and that would have a breakeven of $121.15. The traditional single leg option has a smaller maximum loss ($3.85 vs. $6.09) We chose a relatively long time to expiration on this trade as we think there could be a sizable cyclical move ahead. A longer time to expiration will allow time for the trade to fulfill our expectation.This would occur if the share price traded below $60.00 at expiration, which is about 7.1% below the current price. With an expectation that the share price will trend higher over time, we expect the spread to ultimately expire worthless, allowing investors to keep the premium collected up front.
If the tide in the interest rate picture has indeed turned, we would not be a surprise to see interest rate rise by 1% or slightly more over the upcoming year to 18 months. Such a move would take over 15 points out of TLT, maybe more.
I am short TLT with options.
