On Bloomberg Television Monday, GAMCO Investors portfolio
manager Larry Haverty offered a stark warning for bond
"We have a bond bubble... And the public, I am totally
convinced, does not understand it's going to be possible to
lose money in bonds."
Haverty didn't predict precisely when this bubble would burst,
but fortunately for ETF investors, it is possible to hedge some
bond ETFs. In this post, we'll focus on the most heavily-traded
bond exchange traded fund, the iShares Barclays 20 year+
Treasury Bond ETF (
). Note that, although this ETF invests in bonds backed by the full
faith and credit of the United States government, those bonds are
not without risk. One of the risks associated with Treasury Bonds
is interest rate risk. As iShares
"As interest rates fluctuate, the present value of the bond
and its future cash flows will change, which, in turn, affects
its market price. The relationship is an inverse one-as rates
rise, a bond's price will drop, and vice-versa. Consider a bond
that pays a 5% coupon when prevailing interest rates are 6%. An
investor would not want to pay the full face value for that
bond in the secondary market, since he or she could obtain a 6%
coupon by purchasing a newly issued bond. Thus the price of the
bond paying 5% would need to adjust downward to compensate for
its below-market coupon rate."
Downside Protection For TLT Investors
For TLT investors considering adding downside protection, here
are two ways to hedge this ETF against greater-than-15% drops from
its current price over the next several months.
The first way uses optimal puts*; this way has a small cost, but
allows uncapped upside potential. These were the optimal puts, as
of Monday's close, for an investor looking to hedge 1,000 shares of
TLT against a greater-than-15% drop between now and June 21:
As you can see in the screen capture above, the cost of those
optimal puts, as a percentage of position, is quite low, 0.40%.
A TLT investor interested in hedging against the same,
greater-than-15% decline over the same time frame, but also willing
to cap his potential upside at 10% between now and June 21, could
use the optimal collar below to hedge.
As you can see at the bottom of the screen capture above, the
net cost of this optimal collar is negative - that means that the
TLT investor would be getting paid to hedge in this case.
*Optimal puts are the ones that will give you the level of
protection you want at the lowest possible cost.
uses an algorithm developed by a finance Ph.D to sort through and
analyze all of the available puts for your stocks and ETFs,
scanning for the optimal ones.
**Optimal collars are the ones that will give you the level
of protection you want at the lowest net cost, while not limiting
your potential upside by more than you specify. The algorithm to
scan for optimal collars was developed in conjunction with a
post-doctoral fellow in the financial engineering department at