Score with Soaring Yields

by Tyler Craig | January 29, 2013 8:37 am

In an otherwise boring trading session on Monday, the 10-Year Treasury Yield marched quietly higher to 2%. While this particular threshold is still quite low by historical standards, it’s the highest yield in over nine months and yet another sign that risk appetite is on the rise[1].

Because rising yields go hand-in-hand with falling bond prices, bulls of all stripes should count this as one more in a long line of positive developments propelling the market’s current up-thrust.

Even the most ardent skeptics must admit the amount of bullish evidence is becoming overwhelming. Outside of the easiest and most important fact that the S&P 500 index just REFUSES to go down of late, consider the host of other improvements validating this bull run:

  1. Offensive sectors like financials, consumer discretionary and industrials have been outperforming.
  2. Small- and mid-caps aren’t just leading, but soaring to new all-time highs.
  3. The Dow Jones Transportation index also recently reached new all-time highs.
  4. The market rally hasn’t been a narrow, exclusive surge limited to just a few industries. It’s been a rising tide lifting a multitude of stocks representing a broad swath of sectors and industries. The market’s breadth has, indeed, been quite impressive.
  5. Junk bonds[2] have also climbed to new multi-year highs, revealing that investors are snatching up lower-quality, higher-yielding bonds.
  6. U.S. Treasury bonds continue to see outflows, driving yields higher.

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Keep in mind the 10-year Treasury made two prior attempts to reverse into a sustainable uptrend since mid-2011, which failed miserably (yellow blocks in chart). Will the third time be the charm?

If you think bond prices will continue to be under pressure (thus pushing yields higher), then consider selling puts on the Proshares Ultrashort 20+ Year Treasury Fund (NYSE:TBT[3]). In the short run, TBT moves in lockstep with 10-year Treasury yields, so it serves as a pretty good proxy for betting on yields.

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You could sell the March 62 puts for 75 cents or better. As with all short put strategies, the max reward is limited to the initial credit received — 75 cents in this case — and the max risk is the strike price sold minus the initial credit — or $61.25. In the event yields continue to rise, TBT should remain above $62, and your puts will expire worthless, allowing you to keep the max profit. To minimize the position’s risk, consider buying back the puts if TBT falls beneath $62.

With TBT already up about 5% in the past week alone, you might wait for some type of pullback before selling the put option.

At the time of this writing Tyler Craig had no positions on any of the aforementioned securities.

  1. risk appetite is on the rise:
  2. Junk bonds:
  3. TBT:

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