Less Than ZeroWhen traders fled into Treasuries last week to avoid mortgage-related risks, they inadvertently put greater pressure on Fannie and Freddie. As
|Prepayment Risk Still Falling |
Rising Sun, Falling RatesBetting on an end to the bond rally seems logical; the risk/reward of lending money at present yields doesn't seem appealing. But the toughest trade often is the best trade, and if we take a look at some updates of charts presented here
|A Tale of Two Rates |
|Ten Years After |
Credit Spreads for the Common ManExchange-traded funds may not be the greatest thing since sliced bread, but they're well ahead of whatever's in third place. Let's compare two of them, the iShares GS$ InvesTop ( LQD) and the iShares Lehman 7-10 Year Treasury ( IEF), with an eye toward developing a trading strategy. Since the creation of these ETFs last July, the spread between the two as a function of Treasury yields has gone through two shifts. The first occurred at the October 2002 low for stocks; once equities rebounded, corporate credit spreads started to narrow. The second shift, also in a narrowing direction, occurred at the start of the war in March 2003. Overall, the trade of being long corporates against Treasuries, as represented by these two ETFs, has been a winner for the corporates.
|A Tradeable Corporate Rally |
It's important to remember how difficult it is to create any sort of bond index. Each and every day the maturity of the underlying bonds is one day less. Combined with the effects of "rolling down" the yield curve and the changing impact of each basis-point shift in yield on the bonds' prices, you have a very nonlinear package of moving targets. These effects can be illustrated in a scenario table created by converting the bonds underlying each ETF into a bond portfolio and shifting the yield curve higher and lower by 50- and 100-basis-point increments.
|Comparative Portfolio Performance: 90 Days Hence |
|-100 bp||-50 bp||Flat||+50 bp||+100 bp|
|Value of 1 Basis Point|
In both the higher- and lower-yield cases, LQD appears to be the superior asset; it makes more and loses less. This suggests that buying LQD and selling IEF will continue to be a winning trade, a successful bet on the closure of credit spreads and on the renewed acceptance of risk on the part of investors.