What Economists and Philosophers Have in Common

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%.

See larger image

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…

  1. 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
  2. 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 downturnrn.