Other Voices: Cheap Protection For Your Bond Holdings

Investors Alley's Jay Soloff outlines a simple strategy to protect your bond holdings if interest rates continue to fall

By Jay Soloff

The stock market has been plenty volatile over the last couple weeks, but the real story has been what’s going on in the bond market. Many of the financial headlines you see are about the inverted yield curve or the parabolic move in US bonds.

Let’s start with the inverted yield curve. What does that even mean? First off, the yield curve refers to the yield of Treasuries for all of the available time horizons. This is also known as the Treasury term structure or Treasury curve. It basically runs from 1 month T-bills to 30 year T-bonds.

Normally, when the US economy is in growth mode, the lowest yields are in the shortest-dated bonds and the highest yields are from the 30-year bonds. This makes sense due to the cost of carry for having money locked up in bonds for longer periods.

However, when there is fear of a recession, the curve can get inverted. That is, short-dated Treasuries can have a higher yield than longer-dated bonds. If investors expect a slowing economy, they can be in a rush to buy bonds before yields get lower. Also, short-term government bonds are a safe place to park money during times of uncertainty.

This high demand for short bonds can (and does) invert the yield curve. In most cases, the curve will invert prior to a recession officially happening. As such, many investors count an inverted yield curve as a surefire forward indicator that a recession is on the way.

Even now, the economic numbers don’t look terrible, but the Treasury curve has become inverted. That’s why all the headlines are talking about a looming recession. What’s more, bond buying activity has been extreme.

You can see from the chart of iShares 20+ Treasury Bond ETF (TLT) just how much buying has been going on in bonds. TLT is the most actively traded ETF when it comes to government bonds. The move in TLT in August is nothing short of parabolic.

As you probably guessed, moves like the one in TLT are not the norm for bonds, which are generally far less volatile than stocks. The question is, what’s next for bonds after such an unusual move? Let’s look to the options market for clues.

A recent, large covered call trade in TLT may provide some insight as to what institutions expect for the next month. A buyer purchased 450,000 shares of TLT at $144.97 while simultaneously selling 4,500 of the September 20th 145 calls for $2.65.

The transaction resulted in the buyer collecting $1.2 million in premiums. This premium money means the TLT shares are protected down to $142.32 before any losses occur. However, the calls were sold at-the-money, so max gain is at $145 or roughly the price of TLT at the time of the trade.

This is essentially a yield and protective trade. The trader doesn’t expect TLT to significantly exceed current levels, but also doesn’t expect a big drop. If the price remains at the present level over the next month, the position will earn a yield of 1.8%. That’s just for a month though, annualized it’s 21.6%.

This is the sort of trade I strongly recommend if you own bonds or TLT and want to generate additional yield on your holdings. Plus, it offers a small amount of protection to the downside should bonds end up selling off in the next month.

This article is sponsored by Tim Plaehn, expert on income investing and a friend & colleague of mine at Investors Alley as well as a contributor on SeekingAlpha. Tim runs the Dividend Hunter newsletter which offers a solid & diverse selection of attractive high yield plays. The service now has 9,000 active subscribers and can be had HERE for the rock bottom price of $49 (It usually is $99) for the first year. There are few better bargains around for those looking for solid income plays to balance their high beta holdings especially when equities get volatile!

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