EnvisionCap.com: Forbes Article - High-wire Treasurys

High-wire Treasurys

Marilyn Cohen, Forbes Magazine, 02.24.97

LET'S SUPPOSE that you are bullish on government bonds and you want to wager some serious money on your conviction. There are three good ways to place the bet. They all have their pluses and minuses; they all pack plenty of leverage.

We'll assume that you want to take a $500,000 position in the long Treasury, or a roughly equivalent position in a derivative instrument. The 6.5% due Nov. 15, 2026 was recently trading at a bit more than 96 cents on the dollar, for a 6.8% yield to maturity. Its duration, or sensitivity to interest rate changes, is about 13 years.

What this means is that a 1-point move in interest rates gives rise to a 13-point move (very roughly) in the bond's price. If you are right, and yields on such bonds fall by a point to 5.8%, then you get a 13% gain in the price of the bond. If rates rise a point to 7.8%, then the bond's price falls by 13%. It's not quite that simple prices move in a curve, not a straight line but this is a good approximation and gives you a rough idea of how much action is built into this kind of wager. With your $500,000 bet, you could have a $65,000 gain or $65,000 loss.

But if you can handle the risk you can get that same $65,000 move without putting up $500,000. ;

First method: Buy the bonds on margin. Most brokers will let you borrow 90% of your purchase price. In round numbers: To buy $500,000 face value of the 61/2s, you give the broker $50,000 and borrow $430,000.

You will, of course, have to pay interest on the loan. The best of the loans is cheaper than the 6.8% you are earning on the long Treasury. In the lingo of bond traders, you have a positive carry. You're borrowing at 5.8% and lending at 6.8%. This means that if interest rates go nowhere at all, you make a profit, unless trading costs eat you up.

If you go for the full leverage, that hoped-for $65,000 profit would represent a 130% return on your down payment in a few months, not just 13%. If it goes the other way, you lose it all, and owe your broker $15,000 to boot. Remember, you are borrowing short to lend long, a speculation that sank the savings and loan industry not long ago.

Method two: futures trade. Buy five March contracts on the Chicago Board of Trade Exchange, each contract representing $100,000 face amount of long Treasurys. Recent price for this future: 111 14/32. The June future is a bit cheaper, the December contract cheaper still. You aren't literally borrowing money when you are long a bond future. But you are still, in effect, borrowing short to lend long. (The spread between long and short interest rates is built right into the prices of all these futures.)

You can open the futures position with as little as $2,700 margin per contract, or $13,500. But if the trade goes against you, you are going to get a margin call in the blink of an eye. ;

A 1-point move in interest rates gives rise to a 13-point move in the bond's price.;

Method three: options. Buy five June T bond calls, strike price 112. They were recently trading at 1 57/64 apiece, or $9,453 for the lot. Advantage: You can't lose more than $9,453. Disadvantage: Rates have to move down appreciably for you to make money. If they stay flat, your option will expire worthless.

If you are game for this kind of speculation, do it carefully. Shop around for the best price before buying or selling a bond. Also, shop for the best margin interest rate. On a $430,000 debit balance, Schwab recently quotd me a rate of 50 basis points above the broker loan rate, or a net 7.5%. Merrill Lynch wanted 8.4%.

You can do better than either of these rates by going into the so-called repo market, the $1.7 trillion market for overnight loans that finance holdings of government paper. To qualify, you must meet the brokerage firm's liquid net worth criterion and do a substantial trade (minimums range from $150,000 to $1 million).

Goldman, Sashes and Bear, Stearns, among others, give retail access to the repo market. They will finance the trade at about 50 basis points above the fed funds rate. That sum recently came to 5.8%.

With any of these methods, if your bet is a winner, your profits will be big; if you are wrong, it will be painful.

Marilyn Cohen is president of Envision Capital Management®, Inc., a Los Angeles fixed income money manager. Visit her home page at www.forbes.com/cohen.