By T. Erik Conley
One of the most widely held beliefs among market participants today is that U. S. treasury bonds are overpriced and ripe for a correction, if not an outright bear market that could last years. The problem, as always, is the timing.
I've been anticipating the start of this elusive bear market in treasuries for more than two years, and I've lost some money by jumping in too early. I can't say when this 'flight-to-safety' bull market in bonds will finally end, but I can say that we're closer to the end now than we were two years ago. But how can you play this without getting killed?
One way that is attractive on a risk/reward basis, and is relatively low-cost to implement, is by buying the ProShares UltraShort Lehman 20+ Year Treasury /zigman2/quotes/200202000/composite TBT -2.73% and buying protective puts on the position. TBT, which is the exchange-traded fund that tracks the inverse of the long treasury bond market, is trading near its historical low, as you might expect. But that doesn't mean it can't go even lower.
The put options on TBT are relatively inexpensive, perhaps due to the very long-term decline in the price of the index itself. I've been telling my clients to buy TBT if they believe that the rally in bonds is about to end, but to hedge their bet with puts. Here's how the math works out.
Buy 100 TBT @ $18.10
Buy 1 March 2012 Put on TBT with a $17 strike price @ $0.55
Effective cost basis for TBT is $18.10 + .55 = $18.65
The risk/reward profile of this trade is as follows:
To make money on this trade, TBT has to increase by at least the cost of the put options, or 55 cents per share. If this does not happen within the next 2 months, the investor can either exit the trade or extend it by buying more puts with longer duration. I anticipate that two months from now, the equivalent puts would be priced at about the same level.
The downside risk on this trade is $1.65 per share. To get this number, take the difference between the cost of the long position in TBT ($18.10) and the strike price on the puts ($17.00). Add in the cost of the put options ($0.55) and you get $1.65 per share.
With a clearly defined and limited downside risk of $1.65 per share, and an unlimited potential for gains on the upside, this trade is attractive, in my opinion. Remember, though, that the shelf life of these put options is only 2 months, and they must be renewed each time the old puts expire.
It could very well take a long time before the historic bull market in treasury bonds finally comes to an end, but when it does, you'll be in a position to profit from it.
DISCLOSURE: No current position, but the author intends to initiate one soon.