The position that worries me most

by Wayne Ferbert on March 15th, 2012

With the recent market move up, many friends and clients have been asking me if I think it can keep going. I tell them what I always say: “I don’t know but then again I don’t try to time the market – we are always long the market – but hedged. Didn’t you read my book?”

Try asking me a different question: what investment keeps you up at night? You will get a similarly sarcastic answer: “None of my positions keep me up at night because they are all hedged. Didn’t you read my book?”

But if you asked me which positions I have that I spend the most time thinking about, that is a question I can answer. With the market run-up, you would think my answer would be that I spend the most time thinking about my long-market equity and index positions. But I don’t spend a lot of time worrying about those positions.

Instead, I have spent the most energy on my Fixed Income ETF positions that are held for both my clients and my own account. You know from our blog that we keep positions in Investment Grade Corporate Bonds (LQD) and in the High-Yield Corporates (JNK). Both of these ETFs have solid options markets that make them imminently hedge-able.

But with the market move up (and the resulting shift to equities from a lot of sideline money) and the improving economic data, the prices for fixed income ETFs have started to flatten a little. If you ask me, the flattening of the prices has been long overdue. Interest rates are at historic lows – and don’t seem like they can go much lower.

Of course we know, rates can go lower – it might be hard to believe that, but they can. And when rates are this low, it only takes small movements in the rates to cause large price movements in the bond values. This is why I tread so lightly in these positions right now. When rates eventually go back up (and we know they will at some point), the prices for all fixed income will need to go down. These eventual moves down have room to be dramatic.

We like the fixed income ETFs because they have a low cost and they have reliably tracked their indexes. We particularly like them because they offer a solid options market – which enables us to hedge them. But our worry comes when we look at the maturity and duration information. These funds buy and sell the fixed income for you – and roll debt that matures in to new debt out on the maturity curve. In this way, the fund builds a laddered maturity on your behalf. But the result also means that when rates go up, every bond in the fund will go down in price – and the ETF will reflect a new lower price. If you decide to sell the fund, you will experience that price drop.

If you know you will need the proceeds of your bonds for some purpose at a set time, then you would be better off building a portfolio of bonds that match your expected time horizon. Which means get out of your fixed income ETFs and move to a custom bond portfolio that matches your expected maturity needs. This way, regardless of the interest rate moves, you would get all of your principal back at maturity. However, if you use the Fixed Income ETFs because you are filling out an asset class category and expect your fixed income allocation to be a permanent allocation for you (eg, this is your retirement money so the FI allocation keeps increasing), then the fixed income ETFs are a good spot to be.

But I would consider a slight change to your approach. The options market doesn’t think that the LQD or JNK have a lot of room to go higher either. If you try to sell OTM calls on your position in either of these, you’ll notice the premium you collect is not very significant - and has decreased from prior years. However, if you agree that interest rates are not likely to go lower – and more likely to start going higher in the next 18 months – then go ahead and sell the OTM calls for 3, 6, or 9 months from now. There is a little more premium when you go further out on the time curve.

Then use that premium to set a tighter hedge than you already had on those positions. If the interest rate move is coming, then the ETF prices are going to move down. Think about moving to a collar on your fixed income ETFs – mostly because we’d like to see tighter hedges and you need some premium to help fund that tighter downside protection.

On Monday, we are going to post a procedure for using a Bull Put Spread on a fixed income ETF to replicate a similar risk position as a collar (ie, a limited downside and limited upside). But the spread is going to use ITM puts on the higher strike where we can collect a discounted expected value of the dividend. Look out Monday for that article.

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Ed Murray - March 16th, 2012 at 2:26 PM
I like the distinction you made between using the ETF where you play the NAV versus buying a bond ladder if you know that you want to use the funds at some time in the future. It's too easy to get stuck in a single approach and forget that your needs change and you should review your investment strategy. Great article.

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