wmeubank@ocp.kcmo.com
WHAT IF BONDS ARE TOPPING?
Prepared by Jack McIntyre
Strategy #1
Sell the Dec. 117 call options on the Dec. T-bond contract. Take in 1-03/64's, which makes break-even 115-30+. There are 10 days until expiration.
Strategy #2
Buy spread product versus Treasuries (e.g., mortgages and high-grade corporates). These spreads widen as a result of last week's equity-market shake out and offer better relative value.
We've always held the view that once the global equity markets calm down the flight to quality into the Treasury market will dry up and bond traders will be forced to focus on the underlying fundamentals. This should be bearish for Treasuries or at least take them back into the realm of fair value. We expect that fair value means that the Dec. T-bond contract is going to trade with 115 handles. If you look at the economic reports of late they reflect an economy which continues to have strong aggregate demand and therefore, growth should remain strong through the end of the year. Momentum alone probably results in a strong first quarter as well. Bond yields at 6.24% don't reflect this. Yields need to trade closer to 6.50%.
Given our more cautious view on the Treasury market, we feel that the time is right to either hedge up some of your long exposure, or at least take a more bearish posture. One way of doing this is via a uncovered, short call-option position. There are two advantages of this strategy. The first, and strongest influence, is that this position has a negative delta which means that it benefits from lower bond prices. The return is defined as the option premium taken in at the original sale of the option. With implied volatilities having been bid up as a result of the gyrations in the equity market, they are current very rich and should move back towards fair value levels which are in the area of 9.50%, from their current 11% readings. This means that short call-option positions should not only benefit from the bearish price action, but also an overall decline in volatility (both implieds and actual). You can adjust the level of bearish exposure you want to the Treasury market according to the strike price of the option or the expiration date of the option. For instance, lower strike-price calls will bring in more premium, but are riskier positions (you can look at the delta of the option as being the % that it will end up in the money by expiration. Secondly, risk and therefore, premium received, increase as the expiration date becomes further out. As options move toward expiration their time-value decay occurs at an accelerated pace. This is why we prefer the Dec. options.
The second strategy has a number of the same characteristics of the first strategy. When you own a callable- corporate issue you are short an implied-call option (the owner of the call, the issuer, has the right to call the bond). Therefore, when implied volatilities decline, the value of the callable option declines. The same is true for mortgages and, therefore, in an environment of falling bond prices and declining volatilities, MBS paper should outperform Treasuries.
November 7, 1997 MCM, Inc.
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