A lot of investors are complaining quite loudly about the poor yields that today’s bonds offer in this low inflation environment. If we trade them instead, we don’t really care.
Seeing bond yields plummet in value and then hearing people describe the bond market as very bullish right now might not make a lot of sense to a lot of investors, but that’s only because they are focused on one side of bonds, the long side, and on one particular aspect, the yield.
Bonds are so much more than this though. The yield of a bond really only matters a lot to those who are looking for long-term income streams, those who are actually looking to hold them to maturity or until they need the money in their old age. This approach is a lot like holding preferred stock for the dividends, and if dividends go down, you are probably going to be unhappy.
We do need to realize that nominal yields by themselves aren’t really that meaningful, and it’s only our yield net of inflation that we should pay attention to. When inflation goes down, when interest rates in general go down, bond yields are going to go down as well, because the net yield will cause a new equilibrium to be set.
We can take the returns on a deposit account to show this. There are a lot of older folks who pine away for the glory days of interest rates on savings accounts, but that was at a time when inflation was a lot higher as well. If the rate you earned was 6% but inflation was 6%, you just break even, and if it is 2% but inflation is also 2%, that’s the same effect.
We hardly ever subtract inflation from our returns but we need to always do this, otherwise we won’t even know how much we’re making or losing with our money over a period of time. Top quality bonds don’t pay that much actually on a net basis, particularly U.S. treasuries, although they are certainly a safe place to keep your money and at least will allow you to minimize the amount of money that you lose to inflation.
Investing in bonds for yields is pretty tame though to say the least, and considerably more so than stocks. Investors do have a fairly big risk appetite for stocks though, and bonds fall well beneath this, which is why so many people use them as a hedge.
Bumping Up the Potential Returns with Bonds
If we can take on a lot of risk with our stocks though, why not consider doing taking on more with bonds if we can manage it? We’re not going to get there by seeking yields in themselves, nor will be do very much by speculating on bonds for capital gains just by buying and holding them, meaning that we’re looking to buy low and sell higher ideally as we do with stocks.
You can catch them at the right time, for instance in the midst of this big rally we’re seeing now, but overall, they don’t move all that much and also bounce around a lot, meaning no big trends either way usually, like we see with stocks.
There’s also no natural bias to the upside like stocks have, and while you can hold bonds long-term, it won’t be for capital accumulation, it will be for yields, but once again, yields are far from that exciting.
If we really want to see how this is really done, we need look no further than how big financial institutions do it. These are institutions with billions of dollars to spend, but they do not just buy bonds straight up like we do, they use a lot of leverage to do it. They might, for instance, put up $100 million in cash to control a billion dollars in bonds, which means that for every increment that it moves in price, they make 10 times that in profits.
There is a huge amount of money made in the bond market actually through leverage, and while we may think that it’s too risky to borrow or to just put up a percentage of the value of the positions we control, with bonds this actually makes a lot of sense provided we know at least a little about what we are doing.
Investors would never want to try this with stocks, and even 2:1 leverage is too much. Investors who invest in leveraged ETFs experience this, and this isn’t even about the risk exposure because that can be very well managed. It’s the cost of borrowing the money that slaps us, and even though it’s not us but our fund that borrows it, stocks just don’t return enough on average to make this anything but a poor proposition.
With bonds though, we don’t have to borrow anything because we can instead just put up a deposit to control a position, and either pay or collect the difference based upon the way the value of our position changes. This can easily be done by trading in bond futures, provided that you meet the minimums. Anyone who can’t though has no business trading bonds because these are still pretty tame assets with leverage appropriate for investors and without enough to put to work with them, you’d be better off doing something else.
If we use 3:1 leverage with bonds though, this can spice them up enough to make them at least worth considering, and allow us to add some real diversity to our portfolio. You don’t want to be putting that big of a percentage of your portfolio in something like this but it can serve to produce some new opportunities, especially when bonds are really moving as they are now.
This actually only makes bonds similar to stocks as far as risk goes, and this therefore should not scare us, even though we may have heard some nasty stories of what has happened to a lot of futures traders. You can get yourself in a world of trouble trading futures badly, but this plan is nothing of that sort. In fact, the risk involved with this bond trading will be less than with our stock positions, since to do this right we’re going to be managing our bond trades instead of just hanging our stocks on the line and hope that the wind doesn’t blow too hard against them.
The Risk and Returns of Bond Futures are Pretty Close to Stocks
The real beauty of trading bond futures is that we don’t really care what direction the wind blows, because we can get on one side of the trade as easy as the other. We just look to have our money on the right side more than on the wrong side, and we will make some money.
This is a lot better in many ways than just buying bonds with cash, and you can only buy them this way, and can’t bet on their price going down like you can with futures. Bond futures are also far more accessible than buying bonds through a dealer. Futures contracts can be bought and sold with the click of a mouse in fact, or a tap of your finger if you are on a mobile device.
To make this all work, we will need to learn some of the basics of trading, but the good news is that bonds are about the easiest thing to trade because their direction is all over the media. We all know that bond yields have been falling a lot for instance, and bonds move in trends and it’s not that difficult to know whether the trend is up or down which can be discovered with the most basic of chart reading skills.
This does not require that we foretell the future at all, and in fact good traders don’t attempt to do anything like this, as they are only concerned with the present and the immediate future, the next few bars at most. What separates traders from investors is not their outlook so much as their attention level, where if the trade gets off course, there is no hoping here, we just close the position and move on.
Futures contracts are of a short duration though, and we might think that since we do not expect to be trading in timeframes of three months, this isn’t for us and we’ll leave this up to those who trade this stuff. That’s not really the case though as we can stay in a bond position forever if we want, although we really don’t as bonds shift course fairly frequently. All we do is let the money ride and have it roll over into the next contract if we do choose to continue to hold it.
This is not an idea that is promoted, but it is one that we should at least consider. This is not for everyone and far from it, as there are some real skills that are required and if you are an investor that wants to minimize your participation and decision making, futures trading would be far from a good idea for you.
This is not really that far removed from those who like to time their stock positions, although with bond futures you don’t get trends anywhere near as long as you do with stocks and the holding period will therefore be shorter in duration.
The last couple of years have been on the more volatile side for bonds, and we’ve seen the 10-year treasury drop by about 6% between September 2017 and November 2018, and then gain about 6% since. Gaining this 6% may not seem that exciting, and it really isn’t, but if we triple that with a little leverage, now we’re talking, and this bit of spice does bring bonds up at least closer to where stocks sit as far as the potential for returns, although this is still tamer.
These two moves have been particularly nice ones though, and there will be times where bonds are trading fairly sideways as well. The real benefit here is actually the opportunity to play with bonds in a comparatively safe way should we wish to without being chained to some pretty terrible returns compared to stocks when they are running badly.
You can set whatever leverage you want up to the maximum with futures, by keeping back certain amounts of cash in your account to balance things. This is already close to the maximum anyway as the maintenance requirement is 25% or 4:1 so that’s only a little more than 3:1. Even if we trade badly, we can’t get ourselves into too much trouble with this, unlike some other futures contracts where you can leverage your account out of existence if you are not careful.
Unlike stocks, which can move a long way over a long period of time, bonds don’t really move that far so the risk of being on the wrong side of a move is minimal compared to what can happen with stocks, where you can lose half of your money or more to a crash or a bear market, which makes this all even more appealing.
10-year treasuries do not crash and at top speed they still move very slowly, like a turtle. 6% in 8 months like we’ve just seen is very fast for a bond, and this has all been shouted from the rafters all the while. There is ample opportunity and then some for investors at least somewhat aware to keep their risk well under wraps, especially compared to stocks.
Investors trading futures may seem like a crazy idea at first, but when we look closely enough, it’s actually not crazy at all and can be a fine idea indeed for investors who don’t mind being active.