While much of the focus of late has been on the very strong rally in stocks, bonds have also had a nice move higher off their recent lows. Since the lows on 5/19, the main bond ETF (TLT) has rallied nearly 4% and is now trading right below the trailing 50-day moving average (something it has been below since early March). Not surprisingly, the rally in bonds coincided with the sharp pullback we have seen in crude (which also peaked around 5/19).
Bonds (TLT) have rallied nearly 4% off their recent lows and are now sitting right below their 50-day moving average
Oil peaked around 5/19 and has since declined by over 17% to the breakout uptrend (following the attack on Iran)
Now that bonds have rallied, and oil has declined to potential support, I believe this is an attractive time to consider adding tactical rate hedges in TLT. Also of note is that the key bond proxy (10-year yields) have also pulled back to a potentially key support level which further supports establishing new hedges in TLT (even though the duration is longer).
10-year yields have also pulled back to potential support
Why I also favor adding new hedges here in TLT is that 2-month (July) 40-delta put vol has moved back down to the 10 level. This vol has marked the floor to vol in TLT since mid-January, and off this level we have seen volatility spike a few times already when yields have moved higher (and TLT has declined). In addition, TLT implied vol now trades at a slight discount to 60-day realized vol (another reason why I like owning hedges at this time)
TLT 2-month (July) 40-delta implied vol back to the 10 “floor” level, and now trades at a slight discount to 60-day realized vol
Against this technical/vol backdrop, we will soon be getting a slew of data on the economy and inflation that could certainly impact rates. This Friday, 6/5, we will get the May payroll data and the following week we are due to get the CPI data on 6/10 and then the PPI data on 6/11. Any of these reports could move yields back higher, especially given the sharp countertrend rally we have seen of late. Not to mention, with no definitive agreement out of the Middle East, we could see oil move back higher (which would also likely weigh on bonds here as well).
I prefer to look out to July here to establish some longer-dated hedges while vol has moved lower as yields have come in. Here is a trade I favor at this time:
Buy TLT July 17th 85/80 put spread for $0.85 (TLT Fri close ref of 85.76)
Trade Details:
- Buying the July 5-point put spread as a rate hedge following rally off the recent lows
- Put spread starts ~ half a percent lower (after the expected ex-div on Monday morning)
- Trade offers a 4.7x to 1 max payoff on the limited-risk hedge/bearish bet
- TLT was below 83 about 2 weeks ago. This trade has SEVEN weeks of duration and the downside breakeven is ~ 1.5% lower (after factoring in the next dividend)
- Good hedge to another potential spike in crude, as well as any further inflation scares (July hedge will capture the next 2 months CPI/PPI reports)
- Please contact me or the 22V sales team for updated pricing and execution capabilities
Credit hedges in LQD also look compelling
While I do strongly favor adding low-cost rate hedges here, I also wanted to highlight a credit hedge idea (that also has an embedded rate component) that I believe should also be considered at this time.
The main investment grade ETF (LQD) is essentially a proxy for both yields as well as IG credit spreads. With a current duration of ~ 8.6, the yield component of LQD should closely track what the 10-year yield does. As I mentioned above, 10-year yields have moved back lower towards longer-term support on this latest rally and could be poised to move back higher. In addition, IG spreads have also been moving lower (tightening) ever since the equity markets bottomed at the end of March. With IG spreads now back near the “tights”, and on the longer-term support, it may be difficult for them to move much tighter even if equities continue their ascent. With yields potentially set to move back higher, and IG spreads also at a level that may be inherently difficult for them to move much lower (tighter), it appears LQD may be at risk of a move back lower after the recent rally.
IG credit spreads have moved back toward the “tights” and may not be able to move much lower even if stocks continue their sharp rally
LQD has rallied off the lows as both bonds and credit spreads have rallied. The question now becomes how much more do they have to go?
While 2-month (July) 40-delta put implied vol for LQD hasn’t quite moved back to the recent lows ~ 6, I still like the risk/reward of owning low-cost July put spread hedges in LQD at this time. Should we see either a move back higher in yields, and/or a widening in IG spreads, I think LQD hedges will perform quite well.
Trade:
Buy LQD July 108/105 put spread for ~ $0.55 (LQD 109.36 Fri close ref)
Trade Details:
- LQD has 2 dividends before July expiry for ~ .85 so essentially buying the ATM spread after the rally off the lows
- LQD was at 107 just over a week ago and this trade had 7 weeks until expiry
- Trade has a 4.5x to 1 max payoff
- Trade can be used to hedge long IG credit exposure, or as a limited-risk bearish bet on either rates or IG spreads (both) given attractive setup
- Please contact me or the 22V sales team for updated pricing and execution capabilities
