Long-Short Bond Trade: Now With Reduced Volatility!

In a previous post on Deleveraging, I promised I’d talk about an interesting long-short bond trade that I entered last week.

If you believe that US Treasuries are over-valued, or foreigners will lose their appetite for US debt thus forcing up the interest rates, you’re probably looking to short treasuries.  Ok, maybe you haven’t looked in to shorting anything.  In that case, may be you should read this link on Barrons and then come back. (Barron’s thinks that investors are buying gold as an alternative to near-zero yielding treasuries.)

One of the ways to short the Treasuries is buying the UltraShort Lehman 20+ Treasury ProShares (TBT).  This ETF returns twice the inverse of the daily movement in the 20 year T-bill. However, these things never move in a straight line and can be extremely volatile.

Instead, I decided to do something a little esoteric.

I shorted the iShares Barclays 20+ Year Treasury Bond (TLT) and netted $112.10 per share.  I used that money to buy an equivalent dollar amount  of the Alliance Bernstein Global High Income Fund, Inc. (AWF) at $8.29 (that’s buying about 13.52 shares of AWF for every share shorted of TLT).  Unlike the TBT position however, this position yields a dividend! AWF has a yield of ~13.4% while the short TLT position had a negative yield of 3.5% (since I shorted the ETF I need to pay this dividend), which results in a positive net dividend yield of ~9.9%.

Since TLT and AWF might sometimes move in sync, you’d think this portfolio would have a lower volatility than just TBT. Just to be sure, I also calculated the standard deviation of this portfolio on a bloomberg terminal at school and the resulting standard deviation was about 30% lower than for each individual ETF. (The standard deviation is often used by investors to measure the risk of a stock or a stock portfolio. The basic idea is that the standard deviation is a measure of volatility: the more a stock’s returns vary from the stock’s average return, the more volatile the stock. In short, less volatility is better).

Check out the graphs of TLT, AWF and TBT. Remember, TLT is a short position so you need to multiply the returns by -1 and add it to AWF.

long corporate bonds - short US treasuries

From the chart you can see that yesterday both TLT and AWF trended higher and predictably TBT lost value.  However the combined portfolio was slightly positive.

After last years volatile returns, anything that reduces volatility in your portfolio is a good thing!

Note that AWF is mainly comprised of short-term US corporate debt and some soverign bonds. There is a some foreign currency risk involved but with the US Dollar being a lot higher than it was a year ago, I’m willing to take this risk.

[Disclaimer: In case it wasn’t obvious, I’m long AWF (short-term corporate bonds) and short TLT (long-term government bonds).]

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