Buying bonds by buying ETFs

Although today’s article is about bonds we will be using bond ETFs and option indexes to illustrate the concepts. These indexes and ETFs are easy to find and very convenient for traders not interested in trading the actual bonds themselves.

VIDEO: Bond ETFs

There is a common misperception that bonds are “your father’s investment” and not very exciting or profitable. This is not the case. Currently you can buy, and short bond portfolio ETFs and use options to increase your leverage. This is a good time to discuss this opportunity as bonds and their yields are moving quickly. In fact the market moved yields on bonds up very fast today creating a lot of profit for those on the right side of that trade. The chart below is an image of the TNX or the 10-year Treasury note index option. As you can see, the move today was dramatic and very fast. Why did yields move that far so quickly?

10 Year Treasury Note Yield Index (TNX) Daily Chart

The US Treasury has a new mandate from Congress to make $700 billion available for Wall Street rescues and to help reduce the threat of the credit crisis. The Treasury doesn’t just have that money lying around of course and they are going to have to find it through an issue of new debt. Prior to the approval of the rescue plan the demand for Treasury bonds was rising and driving bond prices up. Because bond yields are the inverse of bond prices yields were dropping quickly. This all will change when the Treasury starts to flood the market with new supply.

We know that if the supply curve moves to the right (increases in quantity) and demand stays stable then prices are probably going to drop. That means lower bond prices and higher yields as new bonds hit the market for this massive fund raising effort. This is good for bond investors planning to hold until maturity but can be very bad for bond fund managers. Bond fund managers actively manage their portfolio of bonds and a decline in price is not a good thing. This is particularly true for “sub-prime” corporate bond and emerging market bond funds. You can see an example of the devastation that has be visited upon an iShares emerging market bond fund (EMB) in the chart below. This is a good thing for investors interested in buying puts, selling calls or willing to short the stock.

iShares Emerging Market Bond ETF (EMB) Daily Chart

How long will the trend last? In an unprecedented market environment the durability of a trend is more uncertain than usual but this is an interesting way to consider diversifying into another asset classes and to use the news to your advantage.