{"id":30976,"date":"2023-10-17T19:50:37","date_gmt":"2023-10-17T19:50:37","guid":{"rendered":"https:\/\/prosfunds.com\/markets\/bond-math-shows-traders-bold-enough-to-bet-on-treasurys-could-reap-dazzling-returns-with-little-risk\/"},"modified":"2023-10-17T19:50:38","modified_gmt":"2023-10-17T19:50:38","slug":"bond-math-shows-traders-bold-enough-to-bet-on-treasurys-could-reap-dazzling-returns-with-little-risk","status":"publish","type":"post","link":"https:\/\/prosfunds.com\/?p=30976","title":{"rendered":"\u2018Bond math\u2019 shows traders bold enough to bet on Treasurys could reap dazzling returns with little risk"},"content":{"rendered":"
\n

As investors snap up long-dated Treasurys following a historic rout that has seen the price of some issues cut in half, some traders are using esoteric \u201cbond math\u201d to justify making big contrarian bets. <\/p>\n

Their reasoning is as follows: at current yields, traders looking to profit from price swings in underlying bonds, rather than holding a 10-year or 30-year Treasury all the way to maturity, theoretically have more to gain from a rally than they have to lose should prices deteriorate further. <\/p>\n

\n

Asymmetric returns <\/h2>\n

In a post following a Bloomberg News story from earlier this week, Rich Falk-Wallace, the CEO and founder of Arcana and a former portfolio manager at Citadel, offered an explanation about how the relationship between bond yields and bond prices leads to the prospect of \u201casymmetric\u201d returns. <\/p>\n

That is, investors will profit more from a 50 basis point drop in yields than they would lose from a 50 basis point rise. Bond yields move inversely to prices. <\/p>\n

In a spreadsheet shared with MarketWatch, Falk-Wallace calculated what these theoretical returns might be for a 30-year bond with a 5% coupon. <\/p>\n

According to his calculations, a 50 basis point decline in the yield on such a Treasury bond would result in a total return of 13%, while the opposite would lead to investors brooking a loss of 2.6%. <\/p>\n

<\/p>\n

<\/p>\n

<\/p>\n<\/figure><\/div>\n

The most recently issued 30-year Treasury, known as the \u201con the run\u201d Treasury since it is typically more heavily traded than older issues, has a coupon of 4.125%, according to FactSet.<\/p>\n

To be sure, charts like Falk-Wallace\u2019s have sparked debate on social-media platforms like X, formerly known as Twitter, where some have argued that calculating returns in this way doesn\u2019t tell the full story. <\/p>\n

Andy Constan, founder of Damped Spring Advisors and a veteran of hedge funds including Bridgewater Associates, said returns look less attractive once the \u201copportunity cost\u201d of holding a one-year Treasury bill with a yield of 5.4% is factored in. <\/p>\n

When adjusted for the fact that bond investors can reap a 5.4% return over 12 months while being insulated from swings in prices \u2014 since they are in theory planning to hold the bill to maturity \u2014 the asymmetry disappears. <\/p>\n

Constan didn\u2019t respond to a request for comment from MarketWatch. <\/p>\n

Falk-Wallace acknowledged that Costan makes a valid point. But for traders betting on bonds using an exchange-traded fund like the iShares 20+ Year Treasury Bond ETF
\n TLT
\n (or perhaps even employing leverage via options or Treasury futures), the absolute return in dollars is likely more important. <\/p>\n

To be sure, this kind of bond market theory has little bearing on where prices are ultimately headed. Many other factors, including inflation expectations, underlying U.S. economic data, concerns about mounting U.S. debt, and signs that investors are demanding a higher term premium are having a much bigger impact on prices, analysts say. And just because something looks cheap doesn\u2019t mean it can\u2019t get cheaper. <\/p>\n

\u201cNone of this has to do with what a bond should be priced at,\u201d Falk-Wallace said. \u201cThat is the question for those making a directional bet. Rather, this is a description of potential outcomes.\u201d<\/p>\n

Two key concepts to keep in mind<\/h2>\n

Calculating these potential returns relies on two concepts that investors use to quantify and describe the relationship between a bond\u2019s yield and price. This is where things start to get complicated.<\/p>\n

The first of these concepts is known as duration, which can be described as the change in the price of a bond for every one percentage-point move in the yield. The concept of duration does an accurate enough job at approximating changes in bond prices. <\/p>\n

But it fails to account for the fact that a bond\u2019s price sensitivity also changes as yields rise and fall. That is where the concept of convexity comes in. It accounts for the fact that distribution of potential returns is curved, not linear, which gives rise to the prospect of asymmetric returns. Falk-Wallace illustrated this concept in the chart below. <\/p>\n

<\/p>\n

<\/p>\n

<\/p>\n<\/figure><\/div>\n

Treasury yields have been rising for months, sending prices lower. But recently there have been signs that the selloff might be nearing a conclusion. For example, TLT recorded more than $900 million dollars in inflows during September, according to FactSet data \u2014 the largest monthly inflow all year. <\/p>\n

A recent fund managers\u2019 survey from Bank of America showed that 56% of respondents expected bond yields to trade lower in a year\u2019s time. <\/p>\n

Strategists from UBS Group and Goldman Sachs Group have recently said that they expect Treasury yields are either near, or at, their cycle highs, and will soon head lower. <\/p>\n

\u201c\u2026[W]ith risk asset valuations broadly consistent with this macro assessment and rates having risen to cycle highs, we think near-term risks to spread sectors and bond yields are skewed to the downside, especially when considering the potential for incoming economic data to fall short of expectations or appear outright weak,\u201d said a team of fixed-income strategists at Goldman Sachs Asset Management in a recent note detailing their fourth-quarter outlook. <\/p>\n

On the other hand, investors have recently exhibited some reluctance at bond auctions, which some analysts have flagged as a potentially concerning development. On Thursday, Treasury dealers bought an above-average slug of $20 billion in 30-year Treasury bonds, which sparked a selloff in Treasurys that also helped knock down stocks. <\/p>\n

Treasury yields were back to trading near their highest levels in 16 years on Tuesday as the selloff continued after a brief reprieve last week. The 10-year yield
\n BX:TMUBMUSD10Y
\n was up 14.5 basis points at 4.853%, while the 30-year bond
\n BX:TMUBMUSD30Y
\n yield gained 8.6 basis points at 4.949%. <\/p>\n<\/p><\/div>\n<\/div>\n

Read the full article here<\/a><\/p>\n","protected":false},"excerpt":{"rendered":"

As investors snap up long-dated Treasurys following a historic rout that has seen the price of some issues cut in half, some traders are using esoteric \u201cbond math\u201d to justify making big contrarian bets. 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