The Smart Way to Play a Bond Market Reversal

It’s been a long time since I have written about the bond market. Nine years and one week ago, to be exact. Even then, that article did not recommend buying bonds. Instead, I commented on a change in employers for legendary bond fund manager Bill Gross.

The reason I have not recommended bonds since then is Fed monetary policy. When interest rates are low, bond prices are high. If you bought long-term bonds nine years ago, you have probably lost money on them.

But now, interest rates are sufficiently high to make owning bonds appealing from a long-term perspective. This week, the yield on the 10-year Treasury Bond rose above 4.7% for the first time since 2007.

That is twice what it was paying eighteen months ago, just before the Fed started raising interest rates. Since then, bond prices have gone down as bond yields have gone up.

The damage has been severe. In December 2021, the iShares 20+ Year Treasury Bond ETF (NSDQ: TLT) traded above $154 a share. This week, it fell below $87.

That works out to a loss of 44% in less than two years. That may come as a surprise to people that consider U.S. Treasury securities the safest investment in the world!

U.S. Treasury securities are safe, in terms of their risk of default. However, their fixed yields make them vulnerable to a rapid change in the direction of interest rates.

For the past eighteen months, the direction of interest rates made bonds a bad investment. But now that rates are close to peaking, it may be time to start piling into bonds.

Tapped Out Consumers

The bond fund referenced above is an easy way to participate in the Treasury bond market. Its portfolio consists entirely of bonds issued by the U.S. Treasury. In terms of default risk, that’s about as safe as you can get.

You will also get a 30-day SEC Yield of 4.6%, which is more than respectable. And since the weighted average maturity of its bond portfolio is 25.5 years, that level of income is not going to change much anytime soon.

But what could change soon is the fund’s share price. If the economy goes into recession, the Fed may start cutting interest rates. And if that happens, bond prices will start rising and bond yields will go down.

That’s why I advocate buying bonds now. Interest rates may go a little higher later this year. Fed Chair Jerome Powell has indicated that another rate rise may be necessary to finish off inflation.

But after that, the Fed may be done raising rates. Especially if consumer spending slows down during the holiday gift buying season.

Higher interest rates mean higher borrowing costs. And higher borrowing costs mean less money available to buy goods and services.

Most concerning is the rapid rise in the delinquency rate on credit card loans. Since bottoming out at 1.55% during the first quarter of 2021, the delinquency rate has nearly doubled to 2.77% during the second quarter of this year.

To be sure, that is far below the 4.6% delinquency rate shortly before the onset of the global financial crisis fifteen years ago. But it is also higher than the 2.66% rate during the first quarter of 2020, just as the coronavirus pandemic was getting underway.

Leveraging Your Bet

If you believe that interest rates are close to peaking, there is another way to bet on them going down. Instead of buying shares of TLT, you can buy a call option on them instead (a call option increases in value when the price of the underlying security goes up).

For example, last week while TLT was trading near $85, the call option that expires in January 2026 at that strike price could be bought for $13.

For this trade to become profitable, TLT must rise above $98 within the next fifteen months. Bear in mind, it was trading above that price less than three months ago.

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Let’s say TLT makes it back to the $116 share price that it was trading at fifteen months ago. In that case, the gain on the intrinsic value of this option would be 138%. If you owned shares of TLT instead, the gain would be only 36%.

Owning shares of TLT is the safer way to go. Even if its share price does not appreciate, you would still collect the monthly dividend payments.

But if you are looking for a leverage way to bet on interest rates dropping next year, buying a call option on TLT may be the better way to go.

For that matter, you could do both. A $23,000 investment in TLT today should produce roughly $1,300 in dividend payments over the next fifteen months.

That’s enough money to purchase the call option contract outlined above. If it ends up being worthless, you will still have your shares of TLT to sell for a gain when interest rates eventually go down to recover that loss.

Editor’s Note: If you’re looking for a steady source of income amid these uncertain times, consider the advice of our colleague, Jim Pearce.

Jim Pearce is the chief investment strategist of our flagship publication, Personal Finance. Jim has unearthed a once “secret” income power play that’s giving everyday investors the opportunity to collect huge payouts, regardless of Fed policy or the ups and downs of the markets. To claim your share, click here.

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