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).]

How To Invest In Foreign Currencies & Foreign Stocks

Previously I had mentioned several ways to invest for a recession or a major downturn in the US economy. In that post, I stated that one of the ways to hedge against the declining dollar (apart from my favorite method of buying gold) was investing in foreign currencies.

Several people emailed me asking how to buy foreign currencies.

A few were concerned that they would have to travel overseas and open a foreign bank account. Luckily, it isn’t so difficult. You have 3 choices.

1. Buy Currencyshares ETFs. You can choose between several currencies like Australian Dollar (Ticker: FXA), Swiss Franc (Ticker: FXF), Japanese Yen (Ticker: FXY), Euro (Ticker: FXE), etc. If you have a brokerage account, its as easy as buying stock. This is probably the easiest method. They also pay monthly dividends and are quite similar to buying a foreign currency CD.

2. Open on account with Everbank and invest in their foreign currencies CDs or directly open an account in a foreign currency.

3. Open on account with Interactive Brokers and directly buy foreign currency (this is probably the most hassle so you’re better off sticking with the top 2 methods).

If you’re interested in buying foreign stocks, the easiest way is to buy the ADRs (American Depository Receipts). However a lot of foreign stocks do not trade in the US as ADRs. A good way to play the foreign markets is to buy foreign ETFs. For example, if you’d like to buy blue chip dividend paying swiss companies, the Swiss Helvetia Fund (ticker: SWZ) is a great investment. (I also happen to like the Swiss Helvetia Gold Coins too!). If you think Singapore’s economy is doing well, you can buy the iShares Singapore Index ETF (ticker: EWS). Or if you like Brazil, you can buy the iShares Brazil Index (ticker: EWZ).

For a more comprehensive list of foreign ETFs check out How To Conquer The World For Fun & Profit. If you’re interested in learning more about currency trading or investing in foreign currencies, I strongly recommend Everbank’s free daily newsletter about the currency markets, the Daily Pfennig. It’s really good.