Profit From the Bondpocalypse

The 30-year-old bond bull market has passed through infancy, adolescence and adulthood, and now rests on what many would argue is its deathbed.

The bond bull might have multiple friends to thank for its prosperous life, but none has done more for its longevity than the Federal Reserve. Destined for greatness, the bull was born at a tumultuous time when the Fed, led by Chairman Paul Volcker, sowed the seeds for its life in their multiyear wrestle with the raging inflation beast. While the Fed ultimately prevailed, it took a massive rise in interest rates before the purchasing power thief was finally felled.

At the time, 10-year Treasury yields had rallied north of 15%. With inflation coming under control — commodities peaked in 1980 and began a 20-year slide — gravity took hold and interest rates began their inexorable decline to more normal levels.

Since bond prices and interest rates move in opposite directions, the persistent drop in rates has driven an equally relentless rise in bond prices. The accompanying 30-year chart juxtaposes the decline in the 10-year treasury yield (TNX — gray area chart) with the epic multidecade bull market in the 30-year U.S. Treasury bond (USB).

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The plumbing of rates to such lowly levels and the acceleration in the ascent of bond prices to such lofty heights — in the sunset years of its life, no less — was likely driven by the zero-interest-rate policy (ZIRP) adopted by Bernanke and friends along with the multiple iterations of quantitative easing foisted upon the market in recent years.

In May 2012, 10-year yields had sunk to 1.39%, leaving little doubt that they were approaching the endgame of their ruthless descent. Indeed, the low rates have ushered in a bull market of warnings from the punditry regarding the follies of over-allocation to fixed income at a time when interest rates are likely to be much higher five to 10 years out. A look at Google Trends shows a notable uptick in the web search interest for the term “bond bubble.” The topic possessed little notoriety in the pre-2008 world but has since garnered much attention.

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The price action of late is certainly fueling the argument that the bond bull has keeled over. A wicked brew of an improving (albeit mildly) economy, all-time highs in stocks and a shift in Fed thinking (tapering QE) has proved too much for the aging bull to handle.

Since the aforementioned 1.39% low in the 10-year, yields have more than doubled to as high as 2.92%. At the same time, the iShares 20+ Year Treasury Bond Fund (TLT) has lost as much as 22% in value.

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While the next year for bond prices might not be as bleak as the past one, it is fair to say the path of least resistance is decisively down.

Traders looking to profit from the emergence of a new bear market in bonds have a number of exchange-traded funds at their disposal. Due to its heightened sensitivity to interest rates, the popular long-term bond fund TLT is an apt weapon of choice for profiting from the coming bear.

A simple approach for you option enthusiasts is to buy put options. Because the drop in bond prices will likely be a long slog interrupted by rallies due to the occasional flights to safety, consider buying LEAPS puts such as the January 2015 105 put currently trading for under $12.

To hedge your positions and potentially generate some income from month to month, you could tactically sell short-term puts against your LEAPS put (a strategy referred to as a put calendar). In timing the hedge, the ideal time is after a large selloff when TLT looks primed for some type of counter-trend bounce.

As of this writing, Tyler Craig held a variety of positions in bond-related ETFs.

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