QE2: what’s an investor to do?
October 26, 2010
David R. Kotok
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Inflation, deflation? Higher interest rates, lower rates? QE2? What to do?
Option 1: Very short-term cash equivalents earn 10 basis points in a money market fund. Take no risk, get no return.
Option 2: 5-year zero-coupon TIPS, zero real rate. Consumer Price Index (CPI) goes up, you get paid the inflation rate. No inflation, you get zero. Get deflation and you pay a small fee to the government for the privilege of loaning it money.
Option 3: 5-year nominal US Treasury note earns 1.2% interest. Ugh!
Option 4: 30-year Treasury bonds earn 3.95% interest. Inflation and higher interest rates give you a large capital loss. Deflation and lower interest rates give you a large capital gain. Risk in both directions is high and symmetrical.
Option 5: Reject Options 1, 2, 3, and 4. Buy long-term, high-grade, tax-fee municipal or taxable Build America Bonds (BABs). Against the high-grade municipal bonds sell the US Treasury short, using leveraged ETFs. Match duration of long and short positions. This requires frequent rebalancing and real-time mathematical recalculation. Structure duration to match market-neutral position. Results: 2-3 % cash yield carry. There is a potential capital gain when markets get realigned and sector spreads resume normalcy. Note: this is a sophisticated trade and complex structure. Unskilled investors are advised to study it carefully before attempting a structure like this.
There are a variety of ways to approach the current extraordinary financial market conditions without reaching for yields by sacrificing credit quality. These ways are not easy. They exist because of the zero bound in policy-setting interest rates. We expect to have those rates near zero for a long time. Therefore, new investment structural options are necessary.
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David R. Kotok, Chairman and Chief Investment Officer
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