This article originally appeared as a post on Mr. Top Steps substack, as a guest from the DIscovery Trading Group; and is used with permission.
We just went through one of the most aggressive rate hikes, in Federal Reserve history. Some are wondering if we are at the end of this rate-hike cycle? Or at a ‘mid-point’? Some are still trying to decide. Given recent events and that today is FOMC day, we thought that the following may be a good time for such an article. And keep in mind that the following and similar concept could be used for a cutting cycle, if one beleives such a cycle is on the near-term horizon …
I was asked recently whether I could suggest a more “creative” way one could have stayed long (or got long) Treasury securities in a long-term portfolio while hedging drawdowns during a big Fed rate-hiking cycle like we had in 2022. One option might have been what we will call a ‘credit quality’ basis spread/hedge trade. The idea being to stay long (or get long) Treasury assets while being short similar tenor corporate assets, specifically high yield paper — I’m old, so I still call it JUNK.
For this illustration, I’ll use two iShares ETFs: The IEI, which tracks 3-7 year Treasury paper, and the HYG, which tracks a basket of high yield corporate bonds, mostly BB rated (junk) paper.
Why the 3-7 year Treasury paper specifically as the core long position you might ask? As a general rule with any big move — especially to the down side — same/similar tenor fixed income assets tend to become more correlated. As such, since we are looking to match maturities here, we first look at the composition of the HYG junk ETF and find an average maturity of about 5 years for the underlying portfolio it’s tracking. That being the case, the IEI Treasury ETF is the best match being the ETF product tracking the most similar maturity of Treasury assets at 3-7 years …
Next for the general concept of the trade idea, note that coming into the prospective trade as of the end of 2021 the junk ETF performed quite well relative to the Treasury ETF. But one could speculate that with the coming expected Fed policy actions, prices of both assets might be expected to fall and for correlation to strengthen between the two assets.
If that were to transpire, one might expect the price of HYG to “outrun” the price of IEI to the downside as risk-free government yields and riskier corporate yields converge in response to the coming rate hikes. And in this case, it really was quite ideal in terms of offering what any spreader is always looking to do: selling something that is up and buying something that is down (or up less).
So here is what the prospective trade would have looked like coming into the big Fed policy change cycle in 2022. The current hike cycle and timing is depicted via effective fed funds rate (EFFR) in blue (below). First, note the aforementioned strengthening correlation between the two assets coming into the hike cycle as a sort of confirmation that your concept was sound. Obviously the below image is illustrating percentage returns all the way to presently, but you could have taken it off/managed it at any time in a number of ways of course.
But as you can see, if you were already long or got long JUST the Treasury asset IEI in green roughly as of the start of 2022, you’d be drawn down almost 9% on that position to date, and certainly much more coming into the end of last year. But if you had simultaneously been short the junk asset HYG in red you’d have clawed back all of that loss and then some, booking nearly 13% on the short leg for a theoretical gross profit on the spread of about +3.75% to date. Not bad. Even a small profit is always preferred to a near certain loss.
I’m sure many might be thinking already though, could there be an opportunity setting up to reverse into an exact inverse of this position at some point in the relatively near future? Sure, though as there would have been with this trade idea at the time there are many things to consider — first and foremost of course being WHEN you believe the Fed will cease hiking rates and/or move to a cutting cycle.
Equally important would be whether you anticipate increased default risk in corporate junk in response to any coming recession if that transpires. Just two of many important questions to answer prior to considering this or any similar trade. Regardless of timing though, at some point the spread between risk-free and riskier yields of similar maturities will likely widen once again.
In closing, remember I’m just illustrating a CONCEPT for a trade idea here folks. Important details such as cost of carry for the short leg, etc. are purposely ignored in favor of painting the rough picture. Are there more cost effective methods to express the same idea such as using options rather than just carrying the underlying high yield ETF leg short? Of course, and I’d encourage all to always explore every possibility when deciding exactly how you want to go about putting on and/or carrying any risk.
That said, it’s been my experience in interacting with aspiring retail traders that most are FAR too concerned with specifics like exact entry criteria based on patterns and/or which technical tools they use while giving little to no thought at all to what they are actually trying to speculate on bigger-picture-wise and why they think it might have an edge — regardless of exact timing/entry criteria, etc.
As always remember that EVERY individual trade idea is at base an even money proposition. NOBODY knows what’s going to happen next event by event with any certainty, and regardless of strategy, market or periodicity, edge is most often found over GROUPS of occurrences, not on each idea with linear consistency. Above all, lean toward staying smaller rather than bigger and be militant about managing your risk first and foremost.
That’s my .02