Ever since I can remember, whenever a market commentator uttered the phrase “flight to safety”, it primarily meant one thing – investors were moving money out of stocks and other “risky” investments into the “security” of “riskless” U.S. treasury securities. And for the longest time it sure made a lot of sense. I mean, what could be safer than having your principal and interest backed by “the full faith and credit of the United States Federal government?”
OK, now the fact that you probably just snickered at that last sentence says a lot don’t you think? What the heck exactly has happened in recent years? Buying a treasury bond today is sort of like lending money to a brother in law who, granted has a good job, but has also already maxed out every credit card he holds.
Call it a “personal opinion” but lending money to an entity that is 16 trillion dollars in debt and continues to borrow 40 cents of every dollar it spends doesn’t exactly sound like a “flight to safety.”
To make matters worse, the yield on 30-year t-bonds is presently around 2.7%. If you’re at all like me, the most perfect word that springs to mind is something “slangy” along the lines of “whoodyfreakindo”. To put it into dollars, if you bought $10,000 of 30-year treasury bonds today you would earn an entire $270 per year for the next 30 years. In the meantime if interest rates were to rise just one percentage point – from 2.7% to 3.7% - in the interim, the value of your bond could fall in excess of -27%! If rates were to rise all the way up to 5%, your bond would decline roughly -46% in price.
Sort of brings a whole new meaning to the words “riskless” and “safety”, no?
So Why Would Anyone Invest in T-Bonds?
Based on the numbers above I think that a lot of people are greatly underestimating the potential risks associated with holding long-term t-bonds. Still, if the economy continues to limp along and rates fall even further, the fact is that there remains meaningful upside potential. For example, if long-term rates fell from 2.7% to 1.7%, a 30-year bond could rally over 58% in price.
So if you are confident that the economy is not going to pick up anytime soon and that rates are more likely to head lower rather than higher, then bonds may still be attractive. But don’t forget the risks. It seems only intuitive to suspect that somewhere along the line over the next 30 years, interest rates will rise. And if and when they do, it’s “look out below” time for long-term bond holders.
Could Bonds be Topping Out Now?
Figure 1 displays a weekly (top) and daily (bottom) chart for spot t-bond prices with the latest Elliott Wave count (from ProfitSource by HUBB) overlaid. As you can see, in both cases the price action just completed an upside Wave 5. This is interpreted as a “topping” formation.
Figure 1 – Elliott Wave count for both Weekly and Daily T-Bonds suggest a rally that has run its course
If Elliott Wave were perfect (it isn’t, but here’s a tip: don’t ever say that to a true Elliott Wave believer unless you have a lot of time on your hands) we would now be in the early stages of the next five waves down pattern on both a weekly and daily basis). Is that the case? Only time will tell. But typically, concurring Wave 5’s for both weekly and daily chart for the same market serves as a meaningful warning sign.
Could There be One More Good Rally Left in T-Bonds?
Historically one of the most favorable times of year to be long t-bonds is between the close of August Trading Day #9 and the close of October Trading Day #5. August trading day #9 this year is Monday, August 13th and the fifth trading day of October is October 5th.
Figure 2 displays the cumulative gain achieved by holding a long position of one t-bond futures contract (each point is worth $1,000) during this time period from 1981 through the present.
Figure 2 – Cumulative gain holing long one t-bond futures contract during bullish Aug-Oct seasonal period (12/31/1981-present)
For the record, this period has seen t-bonds advance 24 times over the past 30 years.
One Way to Play
Because of the potential risk in t-bonds if rates rise even a little, I would look to play the potentially bullish seasonal Aug-Oct period using options on ticker TLT. TLT is the iShares Lehman 20+ Year Treasury ETF. By trading options on an exchange-traded fund you can enjoy limited downside risk and can trade in a stock brokerage account rather than a futures account.
In this case I am not looking for anything too “fancy.” In Figure 3 you see the details for buying one October TLT 119 call option. This is essentially a "stock replacement strategy". In other words, we are buying an in-the-money call option that above the breakeven prrice will move point for point with the price of TLT shares. The difference is that instead of putting up over $12,000 to buy 100 shares of TLT, we commit only $605 to buy the option.
Figure 3 – Long one TLT October 119 call
-The maximum risk for this position is -$605, which would only occur if TLT dropped below 119 and we held the position until expiration.
-On the upside, the breakeven point is $126.05 a share for TLT.
-Also, on the upside, if TLT simply rallied up to its previous high of $132.22, this position would register a profit of about $700.
-One more technical note on the potential advantage of using an option position:
The 119 call has a “delta” of 74. This means that at the moment this position is essentially equivalent to owning 74 shares of TLT. So for example’s sake, let’s compare buying 4 October 119 calls (for a net delta of 297) versus actually buying 300 shares of TLT.
-Cost to purchase 4 October TLT 119 calls = 6.05 * 4 x 100 = $2,420.
-Cost to purchase 300 shares of TLT at $124.28 = 124.28 * 300 = $37,284.
So in a nutshell, by buying 4 October TLT 119 calls you limit your cost – and your maximum risk – to $2,420. This is just 6.5% of the capital required to purchase 300 shares of TLT.
Summary
So are bonds perched on the edge of a cliff and soon to start trending lower (See Figure 1)? Or is a near-term bounce soon to unfold (See Figure 3)? As always, time will tell. The critical tasks at hand for investors are to:
-Assess your degree of confidence that the Elliott Wave patterns in Figure 1 are truly bearish for t-bonds.
-Assess your degree of confidence that the August-October seasonal bull time frame will witness a bounce in t-bond prices (FYI: t-bonds enter this period already fairly oversold).
-Consider whether or not you want to commit capital to either a bullish or bearish scenario for t-bonds.
-And lastly decide what type of position to enter based on your outlook, which allows you to maximize profitability while also limiting risk.
The same as it ever was.
Jay Kaeppel
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site
NOTES:
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