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VIDEOBonds Not Ready to Bust
Demand defies decline.
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In the past I've been buying iShares Barclay’s Treasury (TLT) puts and recent option activity has surged in the Proshares Ultra (TBT), which is an inverse ETF and indicates just how consensus and crowded the notion that rates rise has become. I'm now taking a different tact of selling call spreads for a credit, rather than buying puts, to better align with the notion that rates might not spike higher but they have little room to drop further. (See Steve's specific trades with a free trial to OptionSmith)
My change in view stems from weakening economic data, especially on the jobs front, which will keep the Fed determined to keep rates low for that ever-elusive "extended period” that seems to continually stretch beyond vanishing point, beyond the horizon.
Take These Bonds and Shove Them (Under the Mattress)
But perhaps the largest shift in my thinking stems from evidence that there is and will be an underlying structural demand for bonds, regardless of yield, for the foreseeable future. Despite the fact that bond funds have seen a record inflow of funds over the past two years, data suggest that bonds are still under-owned by banks, individuals, and most importantly pension funds. The conclusion is that there's latent demand that will prop up bond prices and keep yields low.
A recent study from the Pew Center showed that state pension funds have a trillion dollar gap between $2.25 trillion in assets and $3.25 trillion of liabilities in the fiscal year ending June 2008. This number is sure to have expanded in 2009 and in fiscal 2010 almost 41 states are now less than 15% fully funded.
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Source: Pew Research
When you fold in corporate pension funds the estimate of under-funded obligations soars to more than $3 trillion. Now layer in traditionally conservative institutional money (such as university endowment funds down to private trusts that waded into the hedge fund/private equity boon only to get burned) and the number approaches some $10 trillion. The thinking might have been that the need to issue debt to fund these deficits will necessarily drive up rates, and that might ultimately be true. But in the near term (the next three to five years) demand will outstrip supply.
Less Breeds More
This is a function of the fact that not only are the above-mentioned pools of money shell-shocked, but new regulation requires that pension funds maintain minimum reserves of at least 65% of obligations in AAA-rated fixed income.
In the past, funds assumed returns between 8% and 8.5%, which now seems outside the realm of reasonable risk/reward in today’s market. So in what seems to defy logic, funds, almost by necessity, are double loading into bonds despite the historically low rates. With the bulk of obligations rolling out over the next 18 years, this should offset supply as long bonds of the 20-plus-year variety are in short supply. Remember, the Treasury stopped issuing 30-year bonds a decade ago.
Change My Stripes But Not My Claws
All this said, I'm still in the ever-growing camp that the risk/reward of owning bonds is becoming increasingly unattractive. But whereas in the past I've been shorting bonds by purchasing puts in the iShares Barclay’s Treasury in hopes, yes it was a hope, that there would be a big bursting of the bond bubble, I'm now taking a more passive view.
That takes the form of selling a call spread for a credit on the notion that rates might not spike higher but they have little room to drop further.
Twitter: @Minyanville/minyanville-markets-2
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