Trading Treasury Rates with ETFs - Part 1

Suppose you wanted to trade interest rates on long-term U.S. Treasury Securities, either as a hedge or a speculative position.[1]

For example, suppose you believe, as do I, that inflation will emerge as a serious problem in the next few years because of our debt excesses. If that happens, interest rates will rise on bonds in general, including U.S. Treasury notes and bonds and, for those bonds already issued before the inflation, their market values will plunge, causing large capital losses for holders. Also the stock market typically performs poorly during periods of high inflation. Therefore a trader with fixed income investments and equities might desire a strong hedge against inflation and rising interest rates.

The futures markets offer a huge selection of hedges against interest rate movements. But not all traders like to trade futures because they dislike the implied leverage and relatively high cash requirements for trading futures, or they simply feel uncomfortable in that arena.

Exchange Traded Funds (ETFs) now offer equity traders, including those operating on a very small scale with limited budgets, a full range of strategies for playing interest rates of different markets, from U.S. Treasury Securities (USTS) to commercial junk bonds, of all maturities, from less than one year to thirty years.

This series of articles will discuss trading with interest rate strategies for long-term USTS primarily using two common and liquid ETFs, iShares Barclays 20+ Year Treasury Bond Fund (TLT) and the Proshares Ultrashort 20+ Year Treasury Fund (TBT) and put and call options for TLT.

The General Strategy

Generally the strategy will be quite simple: (1) If you think that interest rates will fall on long-term USTS then you will buy TLT or buy calls on TLT or (2) if you think interest rates will rise on long-term USTS then you will buy TBT or buy puts on TLT. (I could have included options on TBT in this mix but didn't for reasons discussed in a later article).

The general strategy is easy to explain, but once we consider questions about the proper size of trades, trade timing, and the relationship between interest rate activity on long-term USTS and the market price of USTS and, hence, these two ETFs then the specific strategy becomes much more complicated.

So we will explore this in steps. The remainder of this article is dedicated to describing and understanding the mathematical relationship between the market yields and market values of USTS.

Future articles in this series will explain (1) the TLT and TBT ETFs and how they are structured and why they are suitable, (2) how TLT is securitized and how that affects TLT's price, (3) how TLT puts and calls respond to TLT volatility and interest rate volatility, and (4) the development of trading models that make use of all of this information.

The Relationship Between Interest Rates and Market Values of USTS.

For all yield-bearing (interest paying) financial assets (YBFAs) traded in the secondary markets after their original issue, including U.S. Treasury Securities of all durations, their market values move in opposite direction of their market yields.

For example, consider a 30-year bond originally issued with a par value of 100 paying a coupon rate (original issue rate) of 4% of par annually. If 10 years later newly-issued 20-year bonds were yielding 6% at par, then the 30-year bond with only 20 years remaining in its life would have to also yield 6% to remain competitive. Because the coupon rate is a fixed constant throughout the life of a bond, the only way the old bond can raise its yield is through a reduction of its market value below par. The bond would fall to a value below par and in this case would in fact fall to a value of $77.60.

Where did I get that number?

The relationship between a bond's market value and its market yield is mathematical. Figure 1 Simple Bond Valuation Formula shows that mathematical relationship, and provided the solution for our bond problem above.[2]

Figure 2 Possible Values for 30-year Bond taken from a slide used in a lecture to explain this relationship, shows all of the possible values that this 10-year-old 30-year-bond would assume given a range of possible yields offered by newly issued competitive 20-year bonds. As can be seen in the ranges shown, the old bond can trade as high as 155 (when the new market yield is 1%) and as low as 34 (when the market yield is 14%).

It should be easy to see that in an environment of volatile interest rates a long-term bond like this example can have the same degree of price volatility as some stocks. More important, in an inflationary environment, if long-term bond yields rise to reflect the inflation, then long-term bonds will suffer serious capital losses.

Consider a real example. As we will see, one of the USTS assets used the collateralize TLT is a 30-year Treasury bond that mature on November 15, 2039, has a coupon yield of 4.38%, but on April 30, 2010 had a market yield of 4.53%, slightly higher, and therefore was trading at a discount price of 97.52. Suppose that by November 15, 2013 that because of double-digit inflation this bond had a market yield of 12%. In that case this bond would be trading for 39.84!

So in an emerging inflationary environment, you would want to be short in this bond, or short in something that tracks this bond.

NEXT: The tracking stocks (ETFs) and their options that we will use to do this.

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[1] If the reader is unfamiliar with the types of U.S. Treasury Securities available on the secondary market, review The Market for U.S. Treasury Securities.

[2] For the curious reader, this mathematical relationship and why it exists is explored in much greater detail in the document Bond and Note Valuation and Related Interest Rate Formulas. The formula shown in Figure 1 is derived in this document and more complicated bond formulas are also developed and explained.