Interest rates and the options market

by Wayne Ferbert on May 29th, 2013

We have been pointing out for the better part of the last 6 months that if you had to be in fixed income, you needed to lean towards high yield bonds – and lean away from Treasuries. Our rationale has been simple: there is an imminent risk of rising interest rates. With rising rates comes lower bond prices so we wanted to avoid the price risk embedded in certain bonds.
 
Our most talked about and favorite bond funds on this blog are: JNK (high yield), LQD (Investment Grade Corporates), and TLT (Treasuries). All three have robust options markets. We have been recommending the JNK for the last 6 months because we expect it to have the least amount of price risk in a recovering interest rate environment.
 
Yields have started to creep back up in the last month – with some real price movement in the last 2 days. The positive economic data has many people believing the Fed will need to pull back on its buyback programs.
 
So far, in 2013, we have been spot on with our call on JNK vs LQD/TLT. The LQD is down from 120.99 to $118.41 today. The TLT is down from 121.18 to the 114.65 level. This is really all due to interest rates – as there has been no spike in default risk of any kind.
 
But the JNK has actually lost no ground in 2013. It entered 2013 at $40.71 and is now at $40.94. It certainly has started coming down in the last month – down a full dollar since its high in early May of $41.95.
 
The JNK has been remarkably resilient – as you would expect. The higher the yield in the bonds, the more price strength it will show when rates turn up.
 
If we enter the characteristics of the JNK fund in to a bond calculator, we can forecast the implied price change given a certain change in interest rates. (You can find a good calculator for that purpose here.)
 
We find that the JNK is around 7-8% priced over par right now – as the weighted average time to maturity is just under 7 years, the yield to maturity is 5.94%, and the weighted average coupon of the bonds in the fund is 7.42%.
 
If the yield on this fund were to go up 1% between now and December, the price of the bond fund could expect to go down by about 5%. A 5% decline on the JNK would be roughly $2. While a 1% move in the yield in 6 months would be a significant move, it is not without precedent. When the Fed moves, the moves back up tend to be swift. 

In the JNK, the $39 level would be a 2% move down from here - representing a 1% yield increase.
 
Looking at the options market for JNK, there is a trade I really like here – a bull put spread. You sell the $41 put for December for $2.10 and you buy the $39 December put for $1.00. So, you net $1.10 – or a little over 75% of the dividends you would collect if you owned the JNK. You give up your upside over $41 – but you lock in a worst case scenario of $0.90 cents per share on a $41 bond ETF.
 
If the bond stays flat here, you will make 2.6% in 7 months with no real upside over that. And you worst case scenario is about 2.1%. You real risk is the interest rate pull back – but the trade off is probably worth it. Just make sure you have an opinion on interest rates before you make this move.
 
More than likely, interest rates will move with economic data for the rest of the year – so watch that data closely.



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