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  • "The market can remain irrational longer than you can remain solvent" - John Maynard Keynes

    Monday, July 07, 2003

    I have been thinking about shorting treasuries for a year or so. It turns out to be really complicated so I haven’t actually done anything yet. While watching one of my many finance programs this weekend I found out about a fund whose objective is to increase in value by 125% of the decrease in the value of a 30-year treasury bond. The Rising Rates Opportunity Pro Fund requires a 15k minimum investment and has a management fee of 1.94% of assets annually (which is only a little higher than the 1.85% fee on their S&P 500 index, compared to the Vanguard S&P 500 index fee of 0.18%!). Though the fee seems very high, it isn’t particularly high for a managed fund and is probably much cheaper than the alternative ways of profiting from falling interest rates.

    I had considered Chicago Board of Trade cash settled interest rate options. The problem with them are threefold, expensive to enter, you are paying a large premium for the time value of the option and the longest time that you can purchase the option for is 12 months out. Combining the Rising Rates Pro Fund with a put at 45. That would mean for every option I hold I would receive $100*(45-(new yield*100)). That is a yield of 3.5% (totally unheard of) would pay $1000 per $170 worth of puts to make up for my losses in the fund (this would be a hedge). The problem with options is I am not just asserting that yields will rise but I am also "betting" that it will happen within 12 months.

    Other alternatives include interest rate futures or shorting one of Barclay’s Treasury Fixed Income iShares such as the 20+ Year Treasury Bonds (TLT).

    Before deciding on my course of action I wanted to find out just how historically low the long term treasuries were. I downloaded 30 year bond data from . They have data back to Feb 1977. Looking strictly at this data the 30 year bond median is 8.3% and the median is 7.9%. I didn’t feel that this data really went far enough back and additionally the fed adjusts their discount rate rather than the actual 30 year bond yield. I looked at the correlation of fed funds rates to the 30 year bond yield. The correlation was 0.85 (where a correlation of 1 would mean they move completely in harmony and 0 would mean there is no relationship). Given such a strong correlation I looked at the fed funds rate from 1954 to now as a proxy. The mean difference between the 30 year bond and the fed funds rate was 1.19 with a standard deviation of 2 (showing that the 30 year bonds generally do not hit the peaks or troughs of the fed funds rate but track closely around the middle ground). The average fed funds rate from 1954 to today would be 5.92% (the current yield is 1.25%).

    With the current 30 year yield at 4.68%, there are only 3 months of data out of 318 where the yield was at or below 4.68% since February 1977. Even at 5% there were only 11 months out of 318.

    If it takes 1 year to get to 5% you would have made 6.8%. If it takes 2 years to get back to the mean of the 30 year bond rate, you would have made 77.35%. This is incredibly low risk as even if the fed eases one more time, 30 year bond rates are not going to drop commensurately and eventually they will put rates back up and you will make money. If I was ever going to make a 2-3 year call, you will at least double your money with this investment.

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    Disclaimer and Disclosure Analyses are prepared from sources and data believed to be reliable, but no representation is made as to their accuracy or completeness. I am not paid by covered companies. Strategies or ideas are presented for informational purposes and should not be used as a basis for any financial decisions.
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