For all of time, philosophers have worked to expunge all that is fleeting and artificial in the world, aiming to unveil fundamental truths.
Economists, too, are inclined toward truth-seeking investigation.
How many times have you heard economists – including our very own, here at Dent Research – question false realities with a dubious eye, saying things like “… but real growth is only a, b and c… when you remove the artificial, manipulative effects of x, y and z.”
Yet, for investors and traders who want to profit from today’s markets – whether you call them real, artificial or otherwise – unsustainable market manipulations are a gift. That’s because, eventually, reality strikes and the market’s natural equilibrium snaps back into place.
Today, amidst a feebly-stabilizing economy and a myriad of risks, many question how the yield spread (high-risk yield minus Treasury yield) can be so low. That investors should be demanding a larger yield spread is a logical argument.
Here’s a chart of that spread, currently at 4.1%.
While 4.1% seems low, fact is… it could go even lower. Historically, 2.5% has served as the ultimate floor.
For investors, the fact that the yield spread has a practically impenetrable floor at 2.5% means there’s a lot more upside potential than downside, in the long-run. In the short-term though, the spread could continue to go lower, until it reaches 2.5%.
Clearly, there’s more money to be made betting against high-yield bonds (in anticipation of a rapidly rising yield spread), than there is buying high-yield bonds (and squeezing profits from a move to 2.5%).
But a hedged approach may be the best way to play this situation. Here’s how that would work…
- Sell Short a certain dollar amount (i.e. $500) of a high-yield bond fund, like the iShares High Yield Corporate Bond ETF (NYSE: HYG); and
- Buy an equal dollar amount (i.e. $500) of a Treasury bond fund, like the iShares 7 – 10 year Treasury Bond ETF (NYSE: IEF).
Over the long run, this pair trade will in your favor when the yield spread widens. In other words, when the high-yield bond investors actually demand a high yield!
During the 2008 credit-crunch meltdown, high-yield bond investors demanded a 22% spread over Treasuries. The next crisis should spur a similar move, making the above trade a great way to protect yourself against a downturn.