How to Hedge Against Treasury Positions

by David Fessler, Investment U Senior Analyst
Thursday, August 25, 2011

Last week, Treasuries rallied on the heels of the U.S. debt downgrade by Standard and Poor’s. Quite predictably, investors acted like cows trapped in a barn fire.

They stampeded for the exits, sold riskier assets like stocks and commodities, and dove into gold and bonds.

Blackrock’s ETF Manager couched it this way:

“[Despite the S&P ratings cut] we think it is vital to underscore the fact that the U.S. Treasury sector… remains the largest and most liquid fixed income market in the world.

“[It has] the greatest degree of price transparency and few genuine alternatives.

“While the events that led to the S&P downgrade are certainly of concern, we think the vast majority of investors will continue to utilize the Treasury yield curve as an effective credit risk-free benchmark against which credit spread issues can be judged.”

All the turmoil surrounding the global financial markets has exchange-traded funds (ETFs) and exchange-traded notes (ETNs) that track fixed income markets busier than one-armed paperhangers.

Harnessing Both Sides of the U.S. Treasury Yield Curve

Two relatively new fixed-income oriented ETNs came on the financial scene last fall. They garnered increased market attention recently. It’s understandable when you consider the volatility that’s currently present.

With 400 to 500 point swings in the Dow more the norm than not, investors and fund managers are looking for calmer waters. They may have found them in the form of these two ETNs. Both have been experiencing higher trading volumes, and the amount of assets under management have also seen big increases.

  • The first one is the iPath U.S. Treasury Flattener ETN (NYSE: FLAT). In a nutshell, FLAT is structured to seize returns by “steepening” or “flattening” the U.S. Treasury yield curve. FLAT shares goes up when yield curves steepen, and down when they become flatter. The way the FLAT ETN accomplishes this feat is by employing a weighted “long” position using two-year Treasury futures contracts. It also has a weighted “short” position consisting of 10-year Treasury futures contracts.
  • The second one, the iPath U.S. Treasury Steepener ETN (NYSE: STPP) simply takes the other side of the FLAT trades.

Removing Volatility From Volatile Investment Environments

Hedge fund managers who have a large percentage of their portfolios in fixed-income instruments use these funds as a tool to remove volatility from volatile investment environments, similar to the one we’re experiencing right now.

If you’re a big holder of U.S. Treasuries, you might want to consider utilizing either of the two ETNs discussed above. You’d presumably pick one or the other based on where you think which way Treasury yields are headed.

But before you make any decisions on using these instruments, I recommend you consult with a fixed-income specialist. He or she will be your best source of information if you are interested in hedging your Treasury positions.

Good investing,

David Fessler