To The Moon

Recently, global bond markets have seen massive sell-offs, pushing the yield on the $iShares 20+ Year Treasury Bond ETF(TLT)$ note to around 4.7%, the highest since April 2023. Since mid-September, the 10-year Treasury yield has surged by over 100 basis points in an almost uninterrupted climb.

This trend mirrors the situations in 2022 and 2023, when global equity markets experienced significant declines. However, in this latest round of rising bond yields, equities have only seen mild adjustments. This could suggest that if yields continue to rise, the equity markets may face further downside risks.

Goldman Sachs strategist Christian Mueller-Glissmann and his team highlighted in a recent report that the correlation between stock and bond yields has turned negative once again. If bond yields continue climbing amid weak economic data, it could deal a blow to equities.

The report noted:
"Given the relative stability of equities during the bond sell-off, we believe the risk of a short-term equity correction may rise if negative economic news emerges."

Just yesterday, Morgan Stanley's Chief Strategist Michael Wilson warned that with the 10-year Treasury yield exceeding 4.5%, U.S. equity valuations are under pressure. The correlation between the S&P 500 Index and bond yields has become "significantly negative," posing severe challenges to equities over the next six months.

Goldman Sachs also pointed out that the steepest rise in yields is occurring in long-term U.S. Treasuries. This steepening of the yield curve reflects market concerns over U.S. fiscal and inflation risks, driven primarily by changes in real yields, excluding inflation expectations.

The market has now repriced expectations for rate cuts, predicting only one 25-basis-point cut by the Federal Reserve by July. Market participants seem to maintain confidence in a "Goldilocks" soft landing for the U.S. economy—growth with low unemployment and minimal inflation risks.

UBS strategist Gerry Fowler observed:
"This is all reflected in real yields rather than inflation and is predominantly occurring at the long end rather than the short end, suggesting the market remains optimistic about U.S. productivity growth while showing little concern over tariff escalations."

Could TLT Be Bottoming?

With the rise in Treasury yields, TLT (the iShares 20+ Year Treasury Bond ETF) may have reached a bottom range. What is the best options strategy to go long on TLT? The answer lies in the Diagonal Spread strategy.

What Is a Diagonal Spread?

A Diagonal Spread involves using options with different strike prices and expiration dates. Typically, the long-leg option has a longer duration than the short-leg option. Diagonal spreads can be bullish or bearish, depending on the market outlook.

The Diagonal Bull Spread is an enhanced version of the traditional bull call spread. The key difference is that the two options in a diagonal spread have different expiration dates. Traders buy a longer-dated, lower-strike call option and sell a shorter-dated, higher-strike call option, maintaining the same number of contracts for both legs.

Example: Diagonal Spread on TLT

Suppose an investor is bullish on TLT for the next year. They could buy a call option with a $100 strike price and a June 30, 2025, expiration. This becomes the long leg of the spread, costing $70 based on the latest trade price.

Long Leg:

• Strike Price: $100

• Expiration Date: June 30, 2025

• Premium: $70

  

After establishing the long leg, the investor can add a short leg with a shorter duration. For instance, they could sell a call option with a $90 strike price expiring on February 7, earning $37 in premium.

Short Leg:

• Strike Price: $90

• Expiration Date: February 7, 2025

• Premium: $37

Advantages of the Diagonal Spread

If the short-leg call option is not exercised, the investor earns $37 in premium, offsetting over half the cost of the long-leg option. The short leg can be rolled over monthly, allowing multiple premiums to be collected during the long leg's remaining life. This could significantly reduce the cost of the long call, potentially making it essentially free.

Compared to simply buying a call, the diagonal spread generates additional income from the premiums of the short leg, lowering the net cost and shifting the breakeven point lower. It also gives investors flexibility to adjust the short leg’s strike price and duration based on market conditions, allowing better risk management.

In essence, the diagonal spread is a cost-effective call-buying strategy that investors should explore.