TBT Puts TBT PUTS
January 25, 2010 - 1:21pm EST by
surf1680
2010 2011
Price: 2.00 EPS 4.3% 4.3%
Shares Out. (in M): 0 P/E na na
Market Cap (in $M): 0 P/FCF na na
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT na na

Sign up for free guest access to view investment idea with a 45 days delay.

 

Description

 

I recommend buying a small position of puts on TBT that expire in 2012 and have a $35 strike.  Current TBT price (the underlying) is $47.35, the puts I recommend trade at $1.5-$2.  The gradual decay of TBT from predictable coupons on the underlying long bonds and internal leverage will bring TBT's price to the $35 strike price within 1.5 years, assuming no change in interest rates.   The premium for the put should be in the $3 range at that time, and you'll have a 50% gain.  That is the base case.  It assumes no significant and sustained changes in long bond interest rates.

With this trade you're getting leveraged exposure to the long bond.  The long bond has a powerful inverse correlation with the equity markets.  If the stock market collapses, interest rates for longer term government bonds would likely decrease rapidly as they did in 2008.  The 52-week low for TBT was $35, if that type situation returns you will have a very quick 300-500% return on your position.  You get additional return over time as the coupons and internal inefficiencies erode TBT share price.

If interest rates move higher, and stay higher, you will likely lose all your investment.  Here are my estimates for your total return, given long bond interest rates:


long bond rate in 1.5 years:    investment return from this position:

3% long bond yield:  1200% total return

4% long bond yield:  200% total return

4.57% long bond (current yield):  50% total return

5% long bond yield:  -75% total return

6% long bond yield:  -99% total return

 

Calculations for base case (no significant, sustained change in interest rates):

TBT is leveraged inverse bond fund shorting 20+ year treasuries.   It was introduced in May 2008 with a $70 price tag.   At that same time, the iShare for 20+ year treasuries(TLT), basically the opposite, long side of the trade, without any leverage, traded at $89.  Since that time interest rates have fluctuated, inflation expectations have gone up and down, fear and greed have come and gone, etc.  Currently, interest rates on long bonds are basically the same as they were in May 2008.  So, where is TLT now trading?  It's trading at $92 (up $3) and it has paid out about $6 in dividends.   That all sounds about right for TLT as an iShare proxy for buying a long bond.

Things are not so good for TBT.  You would expect a portfolio full of TBT shares (remember, 2x the inverse) to be down twice the amount of dividends that a portfolio full of TLT shares has paid out (that works out to be 13.7%), and down another 6.7% to account for the $3 in appreciation of TLT.   If that were the case, then TBT would be trading at $56, but instead it is trading at $47.  I don't know the word to describe that $9 loss (15.8% total, 10% annualized).  It's probably due to volatility, internal leverage, administrative expenses, advertisements in Barron's magazine, etc.  Somebody is doing a lot of fancy trading with complex derivatives and whatnot.  Whatever it is, it will likely continue being a drag on TBT's share price.  It is old news that these leveraged inverse ETFs are not the most efficient vehicles in the world.  Their value to the investment community is legitimate since they are convenient and they are allowed in retirement accounts (whereas shorting TLT is not). 

So, going forward, TBT will likely decrease by the following amounts on an annual basis, just as it did in the past:
4.5% for the coupon, roughly doubled because of the leverage = 9%
10% for the volatilty & leverage premium (established above).

I suggest buying the put that expires in 2 years.  I suggest you think about selling the put in 1.5 years (or sooner).  In 1.5 years, if interest rates don't go too crazy either way, I believe the value of TBT will be $35.  I get that number by multiplying the above annualized decreases by 1.5 years.

The value of the puts will be around $3.  I get that price by looking at the current listed price of puts with a strike trading near the current underlying price, that expire in June (approximately 6 months from now).

Black Scholes

Why does this trade exist?  I'm neither a fixed income nor an options guru so this is just my theory and this next paragraph is confusing, so be warned. The price of the put on TBT, as calculated by the formula, doesn't appear to take into account the dividend (coupon) of the real underlying (long bond is the underlying of the underlying).  The long bond pays a coupon that is a big part of total return, and is predictable.  If you are short the long bond, you must pay that coupon to the person you borrow it from.  TBT is short the long bond (x2).  That coupon is a big driver in the decline in TBT's price.  Thus, TBT's price is predictably eroding as if it were paying a large dividend.  The put on TBT is priced only on the existing Black & Scholes inputs of time, volatility and risk free rate, not dividend.  It is effectively paying a dividend every time the long bond pays a coupon but Black & Scholes doesn't see it.   
 
A Black Scholes pricing issue on your side with this trade is that short term interest rates and volatility are low.  If they increase, put premiums will increase regardless of the underlying.  They might also increase the cost of leverage inside of the TBT etf and reduce it's efficiency, causing a further drag on the underlying.  I'm not sure of the mechanics of what goes on inside TBT, so I can't be sure about that.

Long bond fundamentals:

For the last few years I thought interest rates on long bonds were obscenely low.  Would you give the government your money to hold for 30 years for 4.5% coupon when inflation has averaged 3+% over the previous 30 years?  No way!  But let me twist the proposition around:  Would you let a very high quality (and well-armed) insurance company hold $100 for you?  In exchange for holding the $100, they provide all of the following benefits: 

(1) If at anytime over the next 20 years the stock market crashes, you will receive $130 - $200 instantly so you can go out and buy stocks while their on sale.

(2) You will receive $4.50 per year for 30 years if it doesn't crash.

(3) At the end of the 30 years you are guaranteed to get your $100 back (if nothing else because they have an unlimited supply of $100 bills).   You might even get all your money back after 20 or 25 years.

(4) At anytime over the life of the agreement you can back out and get some of your money back (you're uncertain of the penalty for early withdrawal, but it likely goes down over time).  There's always going to be a market for your insurance policy.

 

That "insurance policy" proposition is more attractive to me.  The point of this trade is not to sell you the long bond, or a 30 year commitment.  Exposure to the long bond via a put over the next 1.5 years is a good hedge, and it's not expensive (in fact, it pays you).


The returns of long bonds have been inversely correlated to the returns on stocks.  That inverse correlation has been getting stronger.  If you look at the returns over a 30 year period, there appears to be none.  As you look at more recent periods, the reverse correlation gets very strong.

last 5 years

             (0.933)

last 10 years

             (0.854)

last 20 years

             (0.072)

last 30 years

              0.032


-1 is perfectly inverse correlation
0 is no correlation
1 is perfect correlation.

 

I do not have my own macro-analysis opinion to offer about this trade.   I understand the argument either way on which way long bonds may go.  I acknowledge the bond market is quite large and lots of people's opinions are included in the current price.  They all know what the U.S. government's balance sheet looks like: http://www.usdebtclock.org/

 

I found some web materials that discuss the fundamental issues with long bond exposure.

 

Bullish on long bond, from Hoisington Management,

http://www.hoisingtonmgt.com/pdf/HIM2009Q4NP.pdf

 

Excerpt:

Presently, we view the inflationary

environment as benign because: 1) the U.S.

economic system is overleveraged and academic

research confirms that this circumstance leads to

deflation; 2) monetary policy is, and will continue

to be, ineffectual as efforts to spur growth are

thwarted by declining asset prices, loan destruction,

and adverse regulatory influences; 3) the federal

government's spending spree will necessarily

cause taxes and borrowings to rise, further stunting

any economic growth. These factors ensure that

inflation will be quiescent. Interest rates easily can

and do rise for short periods, but remaining elevated

in a disinflationary environment is contrary to the

historical experience. We are owners and buyers

of long U.S. Treasury debt.

 

 

A more neutral prospective from a NY Times article & Grew Mankiw:

 

http://www.nytimes.com/2010/01/17/business/economy/17view.html?ref=business

 

Excerpt:  "IS galloping inflation around the corner? Without doubt, the United States is exhibiting some of the classic precursors to out-of-control inflation. But a deeper look suggests that the story is not so simple..."

 

 

Historical Returns:


Long bonds posted a -16% return in 2009.  That is the worst return they have ever posted in their history, to be fair, it comes after many great years for long bonds.   Still, looking at long bond returns going back to the great depression, we don't see too many -16% returns followed by big negative returns:

Year

T.Bonds

1928

0.84%

1929

4.20%

1930

4.54%

1931

-2.56%

1932

8.79%

1933

1.86%

1934

7.96%

1935

4.47%

1936

5.02%

1937

1.38%

1938

4.21%

1939

4.41%

1940

5.40%

1941

-2.02%

1942

2.29%

1943

2.49%

1944

2.58%

1945

3.80%

1946

3.13%

1947

0.92%

1948

1.95%

1949

4.66%

1950

0.43%

1951

-0.30%

1952

2.27%

1953

4.14%

1954

3.29%

1955

-1.34%

1956

-2.26%

1957

6.80%

1958

-2.10%

1959

-2.65%

1960

11.64%

1961

2.06%

1962

5.69%

1963

1.68%

1964

3.73%

1965

0.72%

1966

2.91%

1967

-1.58%

1968

3.27%

1969

-5.01%

1970

16.75%

1971

9.79%

1972

2.82%

1973

3.66%

1974

1.99%

1975

3.61%

1976

15.98%

1977

1.29%

1978

-0.78%

1979

0.67%

1980

-2.99%

1981

8.20%

1982

32.81%

1983

3.20%

1984

13.73%

1985

25.71%

1986

24.28%

1987

-4.96%

1988

8.22%

1989

17.69%

1990

6.24%

1991

15.00%

1992

9.36%

1993

14.21%

1994

-8.04%

1995

23.48%

1996

1.43%

1997

9.94%

1998

14.92%

1999

-8.25%

2000

16.66%

2001

5.57%

2002

15.12%

2003

0.38%

2004

4.49%

2005

2.87%

2006

1.96%

2007

10.21%

2008

20.10%

 

About the Bid/Ask Spread:

 

I purchased some 2012 $40 puts when the bid was $3.00, ask $3.80.  I put in a limit order for $3.20 and it got filled in a few hours.   A similar strategy is what I would do for the $35 put.  I think the $35 put is a better deal.  Size your position very carefully because you could lose it all if China (or whoever?) sells their long bond stash and interest rates spike (and stay up there!).

 

Catalyst

Erosion of the underlying

 

Deflationary Spiral

 

 

    show   sort by    
      Back to top