Costs of Hedging Treasury Bond Exposure Still Low, but Rising

The chances of a debt ceiling deal


The Intrade prediction market enables participants to bet on whether Congress will approve an increase in the US debt ceiling to $15.1 trillion on or before three dates: July 31, August 31 and September 30. As of Monday evening, these were the chances of debt ceiling deals by those respective dates:

• July 31: 17% chance of a deal raising the debt ceiling to $15.1 trillion
• August 31: 79.5% chance of raising the debt ceiling by that much
• September 30: an 87% chance of raising the debt ceiling by that much

Unfortunately, Intrade doesn't offer a market for betting on whether a debt ceiling deal will be reached by August 2, the putative deadline.


Breaching the debt ceiling need not lead to an imminent default


If congress can't come to a deal raising the debt ceiling in time, the US government will not be able to borrow to pay all of its obligations, but that doesn't mean this will necessarily lead to an imminent default. The government could instead prioritize payments so that holders of Treasury securities get their interest payments as scheduled, while withholding payment from other parties (e.g., by furloughing some Federal workers, or by delaying some transfer payments).


Nevertheless, a failure of congress to reach agreement on raising the debt ceiling would be inauspicious for holders of Treasury bonds. Another point to consider is that, even if a debt ceiling deal is reached, US debt may still be downgraded at some point, which could lead to forced selling by funds which are required to own only AAA-rated bonds.


Hedging against a failure to raise the debt ceiling


In a post elsewhere earlier this month ("Helping House Majority Leader Hedge His Treasuries Exposure"), we noted reports that the House Majority Leader held "up to $15,000 in shares of the 2x levered ProShares Trust Ultrashort 20+ Year Treasury ETF (TBT, Financial)," an amount, we suggested, was probably too low to provide much of a hedge for his exposure to Treasuries.


A more precise way to hedge


As we mentioned in a previous post elsewhere, precision is one of the advantages of using optimal puts, rather than inverse ETFs, to hedge:

• Precision. Say you own 824 shares of Exxon Mobil (XOM, Financial), and you'd like to know how to hedge that position against a greater-than-17% loss. Using Portfolio Armor (available as a web app and as an Apple iOS app) (AAPL), you could simply enter "XOM" in the symbol field, "824" in the number of shares field, and "17%" in the threshold field, and then Portfolio Armor would use its algorithm to scan for the optimal puts to give you that level of protection at the lowest cost.¹

The example above mentions a stock, but as we noted in that post earlier this month, Rep. Cantor could find optimal puts on the US Treasury bond-tracking ETF, iShares Barclays 20+ Year Treasury Bond (TLT, Financial), as a proxy for his exposure to Treasury bonds, in the same way.


Hedging costs as of Friday's close


The table below shows the costs, as of last Friday's close, of hedging against greater-than-15% and -20% declines, respectively, in TLT until Jan. 20, 2012.




Hedging costs as of Monday's close


The table below shows the costs, as of Monday's close, of hedging against greater-than-15% and -20% declines, respectively, in TLT until Jan. 20, 2012. Note that the costs are still relatively low, but have increased noticeably since Friday, after TLT's 1.09% drop Monday.


*Based on optimal puts expiring in January 2012.


¹In that case, Portfolio Armor would round down the number of shares you entered to the nearest hundred (since one put option contract represents the right to sell one hundred shares of the underlying security), and then present you with eight of the put option contracts that would slightly over-hedge the 800 shares they cover, so that the total value of your 824 shares would be protected against a greater-than-17% loss.