Curve Bet

Marilyn Cohen, Forbes Magazine, 3.28.05

Bored with plain old Treasury bonds? Take a flier on a derivative that lets you wager on the spread between long and short rates.

Are there any morsels left for yield-starved investors? Investment-grade corporate bonds are yielding the narrowest spreads in five years: 55 basis points (that's about half a percent) between an AAA corporate and a ten-year Treasury, a five-year low. Junk spreads are also at historically low levels. So here I offer a cautious endorsement of another yield-enhancement strategy: "structured" bonds, which are complex debt securities whose interest coupons vary according to some formula that might or might not work to your advantage. Nominally, these bonds yield 7% or more, but there's a gotcha that makes these things something other than a free lunch. In short, they are appropriate for the right sort of speculator, but go in with your eyes open.

One downside is a huge call risk. As with any bond that might be called away, the call provision makes the bond a lopsided bet. If rates go in your favor, the security gets called away, so you are not permitted to enjoy an outsize return for long. If rates go against you, you might be stuck with this piece of paper for a long, long time.

Next comes the transaction cost. Plain old U.S. Treasurys are competitively priced. With a smallish issue of structured notes, in contrast, you run the risk of getting gouged by your broker. Check out the Bond Market Association's Web site, investinginbonds.com, for current prices to protect yourself (see my Sept. 29, 2003 column for more).

The third and perhaps biggest drawback is that the folks selling these complex securities have bigger computers than you do. Rest assured that an issuer does not float any security that is a mathematically bad bet. Its bond might—or might not—be a mathematically bad bet for you.

All that said, I still find some issues good ways to speculate on certain movements in interest rates. The best structured bonds out there, for my money, are "noninversion" notes, also called "curve" notes. These securities pay outsize fixed coupons as long as the slope of the yield curve remains positive. That's when long rates are higher than short rates.

If there's a negative yield curve, the curve note pays zip for as long as the inversion persists--potentially many long, profitless years. But such a scenario is unlikely. Right now intermediate and long-term Treasury yields are converging because pension funds, hedge funds and Asian central banks are piling money into the long end, flattening the curve. Historically, though, whenever the yield curve has gone haywire and inverts, the inversion lasts for a very short time. Since the bloody bond bear market of 1994 there has been only one period when the spread was negative, and that was for six months in 2000.

The Lehman Brothers Holdings of Mar. 17, 2020, issued Feb. 22, pays 7.25% for five years, then 9% to March 2015, then 18% to maturity. The last of those figures is pretty much a will-o'-the-wisp. If the yield curve behaves normally, Lehman will call the bond when it benefits it the most.

Assuming they aren't called—the first call date is June 17—you get that 7.25% until the yield curve inverts. The rate comparison in question here is between the 10-year and 30-year Treasurys, with the later maturity now yielding just 37 basis points more. Last fall that spread was 65 basis points.

A buyer is betting that long-term yields have gone as low as they can and the structured notes will stay in place, unmolested by call provisions. Of course, if an inversion took place, no issuer would call, because your interest payments would be suspended.

In a similar vein: the BNP Paribas of Jan. 28, 2020. It pays 7% until January 2010, then 10% to 2015, then 20%.

Given the call risk, you would be foolish to pay more than par for these bonds. My last column on structured notes (Apr. 29, 2002) recommended the Freddie Mac Libor-linked notes of Feb. 28, 2012 with a 10.125% coupon that would disappear if short-term money rates went up enough. Rates did not climb enough to trigger the coupon disappearing act, and the note paid its handsome coupon for six months. Then Freddie called it.

Lots of big investors are playing the yield carry game these days, borrowing at low short-term rates and lending out at high medium-range rates. Structured notes are your way to get a piece of the action--along with a concomitant piece of the risk.

Think of it this way: You aren't really getting a 7.25% coupon from Lehman. You're getting maybe 3% for a five-year note and then getting paid a separate 4.25% insurance premium for writing a catastrophic insurance policy for Lehman. If the curve shifts violently, Lehman will collect on the policy by keeping your money interest free for a potentially long time. A modest upside in return for a large but improbable downside. I think it's a risk worth taking.

Marilyn Cohen is president of Envision Capital Management®, Inc., a Los Angeles fixed-income money manager and author of The Bond Bible. Find past columns at www.forbes.com/cohen.

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