Gold In Them Thar Treasuries

by Mike Godfrey, Tax-News.com, New York

07 January 2002

While US Treasuries have become a no-go area for fixed-income mutual funds, they are currently the market sector of choice for many hedge funds and speculative bond traders who can employ derivatives, arbitrage strategies, sell short and leverage their holdings.

Most fixed-income analysts have already called a cyclical low on Treasury yields, even if the Fed goes for one, last rate cut. That means falls in Treasury prices, so money managers are likely to continue moving toward higher-yielding non-government bonds such as corporates and mortgage-backed securities.

Not so the fleet-footed herd of bond predators, who can dine out on the steepness of the Treasury yield curve, which creates a so-called positive carry even for short-dated Treasuries. The two-year Treasury now yields 3.16%
compared to an overnight financing rate around 1.75%. The difference between the two, amounting to 1.41%, is free money for the leveraged investor, as long the note's price doesn't move significantly lower. With longer-dated
Treasurys, the spread is even larger.

It's also currently possible to borrow in overseas markets with low interest rates - think Japan - then buy into US treasuries. If the risk of yen appreciation against the dollar frightens you, then use derivatives to hedge off your exposure.

If the economy continues to improve, expectations that the Fed will raise interest rates will cause short-term Treasury yields to rise as diminishing inflation expectations will cause long-term yields to fall. Investors who expect that to happen can short-sell short-dated Treasuries and use the proceeds to buy long-dated Treasuries. Profits will come on both sides of the trade as long as the spread between long and short-dated Treasuries narrows.

These are just some of the simpler strategies. Rocket scientists can do much, much better! But like all good hedge windows, this one won't stay open for ever. In fact, as soon as 1m people have read this article (don't hold your breath) it will close.

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