The discussions in Washington about raising the debt ceiling have deteriorated badly. The last thing that happened was that president Obama got angry at House Majority Leader Eric Cantor for suggesting that maybe there should be a small short term deal; Obama got agitated and walked out of the meeting. In an unintentionally humorous moment after that, Harry Reid suggested that Cantor no longer be part of the negotiations. I guess Reid would like it better if no Republicans were involved.
In any event, the question arises as to how one can protect his or herself if there actually is a default. Without a doubt, there would be a great number of unexpected consequences if the US defaults. Stocks and bonds would gyrate for sure. At some point, however, interest rates should start to soar. Think of it this way: many of those holding treasury bonds will decide to dump them. Indeed, there are many institutions that cannot hold a bond once it is in default. Others may decide to get out before any further decline comes in the treasury market. Of course, declining prices for treasuries mean rising interest rates. That is why I suggest the use of options on an ETF called Proshares Ultrashort 20+ Year Treasury (symbol TBT). TBT goes up twice as fast as the interest rate on long term treasuries. In other words, if the composite rate for long term treasuries goes up by ten percent (for example from 3.5% to 3.85%) TBT will rise by 20%. TBT, however, has options which can be used to greatly leverage the positions that one takes.
Here is an example that might work in the current crisis. TBT is currently selling at $32.32 and is up about 40 cents on the day. The August 37 calls would cost 11 cents. If there is a breakdown in talks about the debt ceiling and interest rates react by rising just 5%, TBT will rise 10% to 35.55 and the value of the 37 August calls should go up. If there is a true disaster and interest rates go up by twenty percent (which would still leave them a low levels historically), TBT would rise 40% and hit a number over $45 making the value of the options at least $8.00 each on an investment of 11 cents.
It is necessary to understand that an investment like this is best thought of as an insurance policy. You need to hope that you are paying an insurance premium for something that you hope you will never use. Obviously, if there is a deal reached on the debt ceiling, the option values will go to zero. On the other hand, were you to buy 100 of these calls at a cost of $1100 plus commissions and if there is a disaster, you might be able to reap a profit of around $80,000 to offset other losses that would surely be hitting your portfolio.
The calls that I suggest will only protect you until option expiration on August 20, 2011. If there is a muted reaction to the ongoing negotiations, the calls may be at too high a strike price to be of much, if any, help. In other words, the calls are helpful only in the event of a big disaster before the August expiration. You can adjust the option selection for more time or a lower strike price, but that will require increasing the size of the investment needed.
As with all my recommendations, I strongly suggest that you do a full investigation of the security and make sure that you understand the ramifications of what I am suggesting.
Disclosure: I am long a number of TBT calls which I use to hedge many different positions.
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