FROM MUNICIPAL BONDS to futures, options and warrants, there are literally thousands of financial instruments that can be traded on a daily basis. Whether you’re an aggressive trader gunning for capital gains or a lower-volatility investor looking for income, there are many choices out there besides money-market funds and Standard & Poor’s 500 index funds.
Like a four-star film, a successful trade is carefully planned, meticulously researched and delicately executed. And when it comes time to put money on the line, investors should not only like the trade, but also the product they’re trading. Making the right trade at the right time using the right product well, it feels like heaven on earth.
Despite the paternalistic tone coming from nervous regulators these days, new investment products continue to be developed at a speedy clip. Keeping abreast of the latest innovations is critical so that, like Batman, you can pull them out of your utility belt at just the right time.
Some products are outright flops. Folios have been moribund since their much-heralded inception a few years back. The same goes for the Chicago Mercantile Exchange’s bankruptcy futures and the Chicago Board Options Exchange’s options on mutual funds, neither of which gained sufficient volume to justify their existence.
Oftentimes, however, investment products look like flops at first simply because they’re a bit ahead of their time. For example, while the Standard & Poor’s Depositary Receipt, or Spider (SPY), was introduced in 1993, it didn’t really take off until the later half of the 1990s, when the market became much more index driven. International exchange-traded funds, or ETFs, got their start as New York Stock Exchange-listed “Country Baskets” and American Stock Exchange-listed “Webs” (World Equity Benchmark Shares) — both of which languished as world markets underperformed the U.S. during the late 1990s. Webs have since been remarketed as “iShares” and have enjoyed steady (although not spectacular) interest from individuals and institutions alike.
While they’re still in their infancy (with more still to come), I believe the recently introduced iShares fixed-income ETFs are the most exciting new products since the Nasdaq-100 Trust (QQQ). Although bonds have a decidedly ho-hum reputation, the new ETFs’ low-cost, ease-of-use and liquidity offer stock jocks trading opportunities previously available only to futures traders or big institutions.
Although Morningstar’s Christopher Traulsen considers trading bond ETFs “about the dumbest idea we can think of,” I believe using the new iShares to better understand, track and (gasp!) trade the bond market represents a major opportunity for income investors looking to take their game to the next level.
While bonds are usually thought of strictly as stable income investments, their prices do fluctuate — often quite dramatically. Since April, the average 30-year bond fund has gained almost 10%, thanks to a major drop in long-term interest rates. Indeed, despite the national obsession with the Federal Reserve, it’s the market that sets interest rates. And because the market can be volatile, bonds — like stocks — can be traded for short-term profit.
Although there are thousands of bond mutual funds to choose from, with the exception of the CBOE’s thinly traded interest-rate options and Merrill Lynch’s soon-to-expire Bond Index Note (BNX), I can’t think of a (non-futures) product that offers individual investors the ability to short sell bonds (that is, bet on higher interest rates) as easily as the new fixed-income iShares. While investors in years past could buy gold funds or short utility stocks to capitalize on rising interest rates, shorting bonds (or bond fund ETFs) outright is much more of a pure play on higher rates.
In addition to serving as long vehicles for income or short vehicles as hedges against higher rates, the new fixed-income ETFs will probably be used in conjunction with another instrument as one leg of a spread. We’ve previously discussed spreads within the context of both closed-end funds and Japanese stocks. Generally speaking, a spread consists of a long position paired against a short position in a correlated sector.
The new instruments will allow you to game the yield curve just as institutions do, going both long and short various maturities in accordance with your own expectations regarding rates. In addition, trades can be developed that isolate particular types of risk. For example, pairing a long position in Goldman Sachs InvesTop Corporate Bond (LQD) or a similar open-end bond fund against a short position in the Lehman 7-10 Year Treasury (IEF) can expose a portfolio to business risk while minimizing interest-rate risk.
We’ll unpack a number of trading ideas over the next few months. The important thing to realize now is that this new ability to go long and short specific points on the yield curve (without a futures account) represents a major step forward in portfolio flexibility, no matter how big or small that portfolio might be.
– Originally on Aug 19, 2002 by Jonathan Hoenig
