Bill Gross has a winning strategy to profit from range-bound Treasuries

Janus fund manager using options, or what he calls 'selling insurance' against volatility to benefit if 10-year Treasury yield stays in tight band

Apr 14, 2015 @ 11:53 am

By Bloomberg News

Bill Gross says he has a strategy to build on gains this year, betting the Treasury market will spend the rest of the second quarter in the doldrums.

Even if the Federal Reserve raises interest rates for the first time since 2006, the head of the $1.5 billion Janus Global Unconstrained Bond Fund doesn't see much upside for 10-year Treasury yields before the third quarter. He doesn't think they'll decline much, either.

Mr. Gross said he is using an options strategy known as a strangle to profit from a largely range-bound market through June. The trade, which he introduced in early February, wasn't profitable its first month, as yields on benchmark 10-year notes rallied as high as 2.26%. Since then, Treasuries have gyrated around the range he's targeting.

(More: Bill Gross' Janus fund draws big bucks as performance picks up)

The trade “is basically a form of selling insurance” against volatility, Mr. Gross said in an April 9 telephone interview from his Janus Capital Group Inc. office in Newport Beach, Calif. “And like any insurance company, you just have to sell it at the right price. If you sell at the wrong price and you have an earthquake or a flood, then you lose money.”

To profit, Mr. Gross needs the 10-year yield to stay between 2.1% and 1.7%. It's trading at 1.87%, according to Bloomberg Bond Trader data. The Janus fund Mr. Gross manages has gained 3% during the past month through April 13, outperforming 99% of its peers, according to data from Morningstar Inc.

'YELLEN COLLAR”

Mr. Gross's strategy echoed Bank of America Corp. credit strategist Hans Mikkelsen, who wrote in an April 8 note that the Fed may be targeting its policies to achieve a narrow range for long-term Treasury yields. Mr. Mikkelsen named that trend the “Yellen collar,” which is an options trade named after Fed Chair Janet Yellen that profits if a security doesn't make big swings.

The trade that Mr. Gross has used isn't a collar, which requires ownership of the underlying security. Instead, he is selling options contracts based on his projected trading range for the 10-year yield.

(More: Gross' contrarian bet against the dollar helps him regain footing)

Recent volatility has raised the price of options on Treasuries, Mr. Gross said, making it a better deal for him to sell options to traders willing to pay up to protect against swings in Treasuries. A measure of the price of options that protect against Treasury-market volatility has traded at higher levels than the average for any full year since 2011, according to the Bank of America Merrill Lynch MOVE Index.

“To me, that makes it an attractive sale and an attractive price,” Mr. Gross said. “It's a good business. It doesn't always work. You just have to be careful.”

Mr. Gross, 71, became a billionaire and earned his reputation as the mutual-fund industry's bond king by building Pacific Investment Management Co. in Newport Beach, Calif., into a $2 trillion money manager, at its peak.

He has been caught wrong-footed by the Fed in the past. As Pimco's Chief Investment Officer, he took losses from large bets that Treasuries would fall in 2011 and 2013, and a 2013 bet that inflation would rise. He abruptly left for Denver-based Janus in September after losing a power struggle with management.

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