Enough fluff from me. Here's a serious question for Henry, and whoever else feels like throwing in their two cents worth. Comments and criticisms will be gratefully received.
I find myself wondering about the on-the-run/off-the-run Treasury spreads - you know, that trade which helped out LTCM so wonderfully ;-) A couple of weeks ago I was going over bond prices, bid-ask spreads, yields and commissions with my broker, and was struck at how seemingly generous some of these spreads were. I confess to not writing it down, and to having a faulty memory, but I think I remember seeing 10-15 basis points of yield spread between the on-the-run and six months off-the-run 30 year US bond.
Here's what I found. The bid-ask spreads seemed to be 3/32, for both on-the-run and off-the-run bonds. This is quite a fat spread compared to the 1/32 spread typical (according to my broker) of bond futures. I was surprised though to see that the bid-ask spread for the off-the-run wasn't any worse than the on-the-run, since the explanation I've always heard for the on-the-run price premium (yield discount) is a liquidity preference argument. Perhaps if I was to ask for a quote on $10M or $100M I'd get a different picture?
This morning over coffee I constructed a scenario in which a retail investor might be able to make money on playing this spread. This seems ridiculous ;-), so I'm asking for comments on where I might have gone wrong.
Here's my scenario. Short $X worth of the on-the-run 30 year US bonds (yielding Y%), and buy $X worth of the off-the-run 29.5 year US bonds (yielding Y+0.1%). Hold the position for six months, at which time you'll be short $X worth of off-the-run 29.5 year bonds and be long $X worth of 29.0 year bonds. During this period you will have made one interest payment of Y% and received one interest payment of Y+0.1%, earning you the 0.1% spread. Also, at the end of this time the yield difference between the two will have (hopefully!) shrunk, to (say) 0.02%, yielding you a small capital gain as well.
Here are some numbers, based on an X=$100K chunk. Entering and then liquidating the position after six months will cost a 3/32 bid-ask spread on each leg (short and long). Add in a 1/32 commission for my broker, and this totals to a $250 cost.
Earning a (semi-annual) 0.1% interest differential will be $50 in my pocket.
The capital gain due to an 8 basis points (.08%) yield spread narrowing will be (assuming a bond duration of 12 years) 12*.08% = 0.96%. On a $100K face amount, this is a $960 profit.
This nets out to a $760 profit, over a six month period. Annualized, this is 1.52% of the $100K principal amount.
Now the question is, how much risk was incurred, and how much margin capital was tied up for this six months?
Since I am aiming to realize 8bps of profit, I have to be prepared to defend the position in case yield spreads widen in the meantime, and perhaps even exit (at a loss) if the pain becomes too great, in order to live to fight another day. Let's say I decide that if the yield spread grows from 10 bp to 40 bp, I'll stop out and take my loss -- i.e., I'll risk 30 bp for an 8 bp gain. Since 8 bp are worth $960, 30 bp are worth $3600 -- this is the amount (not including commissions and spreads) that I'll risk on the trade.
Is this a reasonable "really bad scenario", i.e., a 30bp widening? What happened during LTCM? Am I correct in saying that I ought to be able to limit my risk to $3600?
Now we come to margins. I don't know what sort of margins a brokerage will require of a (ha!) retail client for this sort of trade. I'd like to think something on the order of 5%, but I doubt it. If they want 30%, I'll have to set allocate $30K + my $3.6K stop-loss amount for each $100K. This allows 100/33.6 = 2.98X leverage, which boosts the annualized return to 4.52%
So if I put up $33.6K in T-bills, I'd earn about 4.25% on the T-bills and 4.52% on the yield spread trade - an 8.77% return, which involves a maximum risk of $3.6K, which is 10.7% of $33.6K
What if I were able to arrange better margins, or play games to achieve same (derivatives!), and leverage the trade 10X? This would involve putting up $6.4K of margin plus $3.6K of stop-loss, for a total of $10K (say, a T-bill). The T-bill would earn 4.25% interest, the leveraged annualized yield spread would return 15.2%, for a 19.45% return on $10K. Maximum risk would be $3.6K, or 36% of the $10K.
These numbers seem attractive to me. The three scenarios above (1X leverage, 3X leverage and 10X leverage) seem to be "dead-conservative", "conservative" and "enterprising-but-reasonable risk" scenarios, returning 1.52%, 4.52% and 15.2% above the risk-free rate (respectively), in return for taking on risk in the amount of 3.6%, 10.7% and 36%.
So my question is, why isn't everybody doing this? Or is the prospect of a 15% return on a 10X leveraged (bond) trade just too boring to contemplate?
- Daniel |
