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Investment idea, comments?
Old 01-06-2005, 09:47 AM   #1
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Investment idea, comments?

I am trying to think of a way to short credit spreads. Basically, I believe that credit risky bonds are overly bid up and represent inadequate compensation for the risk of defaul compared to treasuries. I think that credit spreads will eventually widen out, and being short credit spreads will pay off.

AFAIK, there is no way to go short credit spreads via any sort of option, at least not if you are a retail investor (institutions can do credit default swaps, and similar). So I think I have figured out a way to do this synthetically using ETFs. In a nutshell, it looks like shorting LQD and going long IEF would accomplish this. Check this out:

Yield, Duration, Maturity, Rating
IEF 3.77%, 6.49, 7.83, Aaa/AAA
LQD 4.58%, 6.43, 9.93, A2/BBB+


Does anyone see any obvious holes in this strategy?
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Re: Investment idea, comments?
Old 01-06-2005, 10:56 PM   #2
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Re: Investment idea, comments?

When think about these kinds of strategies myself (which is not that often), I go and read a few pages from "When Genius Failed", the story of the collapse of Long Term Capital Management.

It cures me.

Not for me, but "Good Luck" to you
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Re: Investment idea, comments?
Old 01-06-2005, 11:06 PM   #3
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Re: Investment idea, comments?

Quote:
So I think I have figured out a way to do this synthetically using ETFs. *In a nutshell, it looks like shorting LQD and going long IEF would accomplish this. *Check this out:
* * * * * *Yield, Duration, Maturity, Rating
IEF * * * *3.77%, 6.49, 7.83, Aaa/AAA
LQD * * * 4.58%, 6.43, 9.93, A2/BBB+
Does anyone see any obvious holes in this strategy?
I don't think there are any holes in it. If the trade moves against you, it can't last so you would probably find it easy to hold on. The cost of carry is reasonable. The only comment I would have is that LQD isn't that bad either, at A2/BBB. Are there any flat-out junk ETFs? Something that could really blow up?

At what spread would you cover? IOW, how much move do you think you will get before you get nervous about reversals? It seems that you will have to take a pretty big position to make it worth your while.

I hope you post more about this trade; it sounds interesting to me also.

Mikey
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Re: Investment idea, comments?
Old 01-07-2005, 08:00 AM   #4
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Re: Investment idea, comments?

I would just like to say that while I understand English, and understand many of the concepts involved in this thread, I don't understand the core of this discussion.

Thanks for showing me yet another area I need to learn more about

So as I understand it, Brewer wants to short LQD which he feels is overvalued (the risk premium isn't high enough)... why then purchase IEF as well? In a period of guaranteed rising interest rates, wouldn't shorting any bond fund work, or has the market already accounted for the future rates?

Thanks for your understanding, and anyone willing to impart a few nuggets of knowledge.
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Re: Investment idea, comments?
Old 01-07-2005, 08:22 AM   #5
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Re: Investment idea, comments?

Quote:
I would just like to say that while I understand English, and understand many of the concepts involved in this thread, I don't understand the core of this discussion.

Thanks for showing me yet another area I need to learn more about *

So as I understand it, Brewer wants to short LQD which he feels is overvalued (the risk premium isn't high enough)... why then purchase IEF as well? * *In a period of guaranteed rising interest rates, wouldn't shorting any bond fund work, or has the market already accounted for the future rates?

Thanks for your understanding, and anyone willing to impart a few nuggets of knowledge. *
What you are missing is that the contemplated trade is NOT intended to involve a bet on interest rates. Although I generally agree that rates will probably go up, I don't believe that I can forecast the timing and magnitude of long term rate changes with any degree of confidence. However, I strongly believe that credit spreads are too thin to compensate for the risks involved.

What I would like to do is enter into a futures contract or buy an option directly on credit spreads. This doesn't appear to be available to me as a retail investor. Therefore, I am trying to figure out how to synthetically create such an instrument. If I look at IEF and LQD, I see that they are pools of bonds with about the same interest rate sensitivity (as measured by duration). That means if I short LQD and buy IEF I should be hedged with respect to interest rate changes. However, if credit spreads widen or narrow, I would gain or lose.

I'm still not sure I necessarily want to do this trade. I'm not thrilled with not limit to my losses, so I may try to figure out how to do it with options, but that method might prove to be too costly.
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Re: Investment idea, comments?
Old 01-07-2005, 06:32 PM   #6
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Re: Investment idea, comments?

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I'm still not sure I necessarily want to do this trade. *I'm not thrilled with not limit to my losses, so I may try to figure out how to do it with options, but that method might prove to be too costly.
I don't get the "no limit" to your losses. It looks to me that if the two funds went to yield parity, an almost impossible situation, you would lose 20% or so. Anyone who is willing to buy anything other than short term paper might find this is pretty reasonable risk. What I wonder is what I asked you above- what is your target for closing out the trade?

You are a bond expert- I guess you have quantified spreads at least by quartiles?

M
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