bonds

In my last post, I hinted at using QE2 to your advantage by investing in companies that benefit from a steepening yield curve. But I didn’t have time to get in to specifics. Which is what I’ll do right now, seeing that I have a couple of hours to spare at the Fort Lauderdale airport.

The Federal Reserve let the market know that it plans to keep short term interest rates at extremely low rates for the next few quarters (if not longer). Companies that can borrow short term, can do so at very low rates. So long as you have AA-rated collateral, you can borrow money at about 0.30% on a 30 day basis. If you plan to borrow for a longer term, you just need to keep “rolling” your loan every 30 days or so.

So if you can invest in a AA-rated bond that pays say 3% or 4% and borrow money at 0.30%, you’re going to profit from the spread. Do such bonds exist?

They do – they’re called Agency RMBS and they’re just large pools of single-family residential mortgages that are bundled together in to large multi-million dollar securities and guaranteed against default by a government sponsored agency such as Freddie Mac or Fannie Mae. They also yield about 3.75% or higher.

So you can borrow money at 0.30% and invest it at 3.75% and you’re guaranteed against loss of principle by a government agency! Sounds too good to be true? Well it gets better!

Companies that use this business model to make money are set up as REITs and pay out a hefty dividend to shareholders. Companies like Annaly Capital Management (NLY),  Hatteras Financial Corp (HTS), Cypress Sharpridge Investments (CYS) are mortgage REITs that are set up to do exactly this. And they all pay approximately 15% in dividends.

An RMBS is basically a bond and all bonds have 3 types of risk:

  1. Credit Risk
  2. Prepayment Risk
  3. Interest Risk

Companies which invest in Agency MBS don’t suffer from credit risk. If the borrower of the mortgage defaults, the government-sponsored agency just buys it back and you get your money back. There is no fear of loss of principle!

Prepayment risk is when the borrower pays off the loan early and returns your principle back to you. This usually happens in environments when interest rates are dropping and borrowers can refinance their mortgages at a lower rate. If you get your money back early, you need to reinvest the money, typically at a lower rate. Given that mortgage rates are so low and refinancing is much more difficult than it used to be, the risk of prepayment is limited. There are some always some prepayments though which occur as regular amortization of the loan. Some companies will calculate how much of their portfolio and try to enter forward contracts to purchase more RBMS and thus mitigate the prepayment risk. CYS is one company that does this.

The third and major risk is interest rate risk. As the cost of borrowing increases, the spread between borrowing and invests decreases. Your profit margins drop and are no longer able to make the kind of returns you’re used to. Again some companies hedge against this event, and incur some cost in doing so. But hedging maintains long-term predictability of cash flows and may be worth the drop in potential yield. Again CYS does this and it’s net spread after hedging is 2.55%. It also uses 7.5:1 leverage to maintain a $4.5 billion portfolio against $600 million equity position. When you earn a 2.55% spread and can leverage up 7.5%, that’s a whopping 19% yield! CYS has about a 17% dividend yield.

Disclosure: I bought a 33% position in CYS on Friday and am going to be buying more under $13.50.

A UK-based chocolate manufacturer, Hotel Chocolat, has come up with a novel way to raise capital for expansion. Instead of borrowing money from banks or issuing regular corporate debt, it has decided to raise about $7.5 million USD by issuing “chocolate bonds“. Instead of a regular dividend payment (well technically it’s a coupon payment and not a dividend), these bonds will pay dividends in chocolates!

hotel-chocolat-box-of-chocolates

In order to be eligible, you need to be a member of their “Tasting Club”, which already has 100,000 members. For an investment of $2,890 USD or $5,760 USD, you can get a juicy annual dividend of 6.72% or 7.29% delivered to your doorstep every other month.

If you’ve ever been to high-end confectionery, you’ll know they charge a couple of dollars for each piece of candy.  So spending a few thousand quid might not be such a bad investment. Especially since bank yields aren’t very impressive right now. At least it guarantees you won’t have to spring for chocolate for three years, even if the rest of your portfolio tanks!

I wouldn’t be surprised a chain of British gyms are next in line to offer special “weight-loss bonds”, with special dividend rates for people who bought the chocolate bonds!

But the real question is whether Inland Revenue will be accepting their tax payment in chocolate too?

One of my favorite investors, Nassim Nicholas Taleb, founder of Empirica investment management funds and author of Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets, was recently quoted on Bloomberg advising every single human being to short the US Treasury bonds. While this news is about a week old, I thought I’d still comment on it given the fact that it’s a pretty strong statement and that I recently exited a similar paired-trade.

Taleb said investors should bet on a rise in long-term U.S. Treasury yields, which move inversely to prices, as long as Bernanke and White House economic adviser Lawrence Summers are in office, without being more specific. Nouriel Roubini, the New York University professor who predicted the credit crisis, also said at the conference that the U.S. dollar will weaken against Asian and “commodity” currencies such as the Brazilian real over the next two or three years.

The Fed and U.S. agencies have lent, spent or guaranteed $9.66 trillion to lift the economy from the worst recession since the Great Depression, according to data compiled by Bloomberg. Bernanke, who in December 2008 slashed the central bank’s target rate for overnight loans between banks to virtually zero, flooded the economy with more than $1 trillion in the largest monetary expansion in U.S. history.

President Barack Obama has increased the U.S. marketable debt to a record $7.27 trillion as he tries to sustain the recovery from last year’s recession. The Obama administration projects the U.S. budget deficit will rise to a record $1.6 trillion in the 2011 fiscal year.

“The problem we have in the United States, the level of debt is still very high and being converted to government debt”, Taleb said in an interview with Bloomberg Television. “We are worse-off today than we were last year. In the United States and in Europe, you have fewer people employed and a larger amount of debt”.

Moody’s Investors Service Inc. said on Feb. 2 that the U.S. government’s Aaa bond rating will come under pressure in the future unless additional measures are taken to reduce budget deficits projected for the next decade.”.

Do I believe him? Absolutely. So why did I exit my highly profitable trade? Several reasons. During times of global economic uncertainity, there has always been a flight to quality. We saw this during the financial meltdown in 2008, where US Treasury prices soared and yields tanked. Right now, there is uncertainity in Europe regarding the debt of Greece, Portugal, Ireland, and Spain. People are worried this might have lasting consequences on the Euro as a viable currency. These fears are probably overblown, but until everything settles down and we have more clarity, there will be a flight to quality, which means that people will sell the Euro and flock to US Treasuries.

At least thats my hypothesis and I sold all my positions (except Berkshire Hathaway), shorted the Euro and also the S&P500. The one thing I didn’t do is go long the US Treasuries, since inherently I feel Nassim Nicolas Taleb is correct. At some point, I’ll most likely re-enter my short US Treasury trade, but in the meanwhile I happy to see how the European Union handles the issues of excessive debt.

Almost exactly a year ago, I mentioned a paired-trade investment between the long-term Bond ETF (TLT) and short-term corporate/sovereign bond ETF (AWF).  I went long AWF and shorted an equal dollar amount of TLT. Last week, I closed the position after holding it for just over a year.

When I entered the trade, AWF was trading for $8.29 and had a yield of 13.4%, while my short position in TLT was trading at $112.10 and had a yield of 3.5%.  When I close out my position a year later, AWF had a price of $13.10 and a yield of 8.6%, while TLT was going for $91.65 and yielding 3.9%.

I made about 63% on the long AWF position and 18% on the short TLT position. Coupled with the 9.9% net dividend yield, that trade made me ~91%. Not a bad return for a year and 4 days.  Bond yields don’t usually move 500 basis points in a year. No point being greedy. Time to bank some profit!

paired-trade-awf-tlt-returns

A drop in the stock market will cause the price of bonds to move up, since they typically are inversely correlated. Similarly a sharp rise in in yields would cause bonds price to drop. I expect a move in TLT to about roughly $96 at which point I might renter the position depending on the larger macro-economic picture.