Chris, I like the paired trade concept, but I think the inflation adjusted bonds are still pretty pricey. Yes, this is the lowest spread they have ever had with regular bonds, but it is still pretty large, IMHO. I would prefer to short zero coupon bonds and buy regular bonds. There, the spread is very small. And the zeros will drop like a rock if rates go up. I haven't done this yet, but my figuring is short 1.25 face amount of zero and long 1.00 face amount of long bonds. To put a little spice into the trade, I would go for the premium bonds with the highest yield to maturity and a much higher current yield. For example, something like the 8 3/4 of August 2020, yielding 5.72 pct. to maturity (which would include the loss of 35 points of capital, and yielding close to 6.48 pct. on a current income basis. That would be my long. Against that, I would short the zeros, May of 2015 for 38 points.
This trade would do well in a rising rate environment. However, if rates continue down, you will eat dirt. The high current yield does help somewhat. And you absolutely have to get a large rebate on your short sale in this position. That is a must because the rebate nearly covers the nominal interest rate on the zero.
BTW, I think we are very close to a cyclical and secular peak in long term rates. Too many slap-dash investors are saying long bonds are a sure thing. Reminds of the Vinick intermediate peak.
MB |
