Reversing the Bond ETF Trade (Follow-Up)

Source: Capital Pixel

On December 12, I wrote a piece to show how professional bond managers approach the fixed income market.  I find, when I talk to potential clients, that the fixed income portion of their portfolio tends to confuse them - especially in today's environment of low interest rates.  Potential clients have an asset allocation which tells them that 40% or 50% should go to fixed income, but they don't know what to do next.  Many of them are making big interest rate call bets - whether they know it or not - and it is costing them.  Instead, this follow-up looks at how portfolio shifts can be made on the basis of yields in different sectors.  If you get the idea, you can use it also to make profitable adjustments on the basis of the yield curve.

The December 12 piece adapts to ETFs how I approached the fixed income markets as a managing director of ASB Capital in the 1990s. This is just trading on the basis of spreads among different sectors.  The objective was to outperform the Barclay's Aggregate Index (actually at the time it was the Lehman Aggregate Index).  The Barclay's Aggregate Index is the bond market equivalent to the S&P 500 Index in the stock market.  Just as most active managers fail to beat the S&P 500 in the stock market, bond mangers tend to underperform their index.

Why is this?  Basically because interest rates look like they are easy to predict when, in fact, they are notoriously difficult.  The bond market, like the stock market, is pretty efficient.  Yields reflect all available information.  Where they go from here depends on news, which, by definition, is unknown until it happens.

The present situation is a case in point.  Most professional bond managers last year this time were convinced that rates were headed higher.  In fact, rates dropped.  Big time bond managers, like Bill Gross of PIMCO, took it on the chin by positioning their portfolios in low-duration fixed income assets.

So, instead of trying to predict the level of rates, many bond managers seek to add value by identifying opportunities where yield spreads basically are "out-of-whack" in various sectors.  The underlying principle is that investors, over time, view risk differently.  Sometimes investors are fearful and will avoid more risky assets (you can read "junk bonds" here) and, at other times, they embrace risky assets.  Their views drive the yield spreads.  Over time, the relationship has an average spread; and this whole idea rests on the notion of what is called "reversion to the mean."  A good way to think of this is in terms of a car veering to the right and then to the left.  Eventually (hopefully) it gets back to the road.

Like many concepts in finance, this idea can be a bit fuzzy in the absence of an example.  So here is the example with a revisit to the December 12 starting point.

On December 12, we looked at HYG, a high-yield bond ETF, priced at $87.26, and IEF, a  7-10 year Treasury ETF, priced at $104.26.  The yield on HYG was 7.97% and the yield on IEF was 2.69%. Selling IEF and buying HYG picked up +5.28% in yield (7.97% - 2.69%).  If you tracked this relationship over time, you would find that this is considerably greater than the average pickup in yield, reflecting investor fear of risk at the time.  Traders would say that risk is cheap in the bond market.

So where does it stand today?  Suppose we had done the trade.  Suppose we had sold some of our IEF position and bought HYG.  Today HYG is priced at $89.58 for a yield of 7.69% and IEF is priced at $104.45 for a yield of 2.56%.  Thus, HYG is up in price by more than 2 points, whereas IEF is up only marginally.  Thus, this was a great trade!  Note that the yields have fallen.  This, of course, is the basic bond relationship.  Prices rise when yields fall and vice versa!

Hopefully this isn't too confusing.  Fundamentally you want to start by trading 2 apples for 3 oranges and then get to the point where you can trade 2 oranges back for 2 apples--at which point you've made a profit of 1 orange!

Today the bond manager approach would contemplate reversing the trade - i.e., selling the HYG position and buying back the IEF.  The overriding factor would be the relationship over a sufficiently long-term period.  This, in turn, is easily accomplished by going to a site such as Yahoo! Finance and analyzing past data.

Disclosure:  The information here is for educational purposes.  I hold HYG and IEF in client accounts.