Something’s afoot with interest rates. At least that’s what option market makers are telling us. Take a look at the expense trend for calls and puts on 10-year Treasury futures.

If you compare the volatility assumption embedded in T-note options, measured by the CBOE/CBOT 10-year U.S. Treasury Note Volatility Index (CBOE: VXTYN), to the 20-day historic volatility of the iShares 7-10 Year Treasury Bond ETF (NYSE Arca: IEF), you can see how market makers have been padding contract prices recently (see the uptrend line in Figure 1). On average, the two volatilities pretty much match each other, but in recent weeks option prices have become rather rich, indicating a heightened risk perceived by traders.

Copyright Chris Hondros, Getty Images

So what’s to fear? Higher interest rates, for one thing. If there was one month out of the year to bet on rising interest rates, it would be October, at least according to the price action in the ProShares UltraShort 20+ Year Treasury ETF (NYSE Arca: TBT). The fund aims to provide double inverse (-200 percent) exposure to daily fluctuations in the Barclays Capital U.S. 20+ Year Treasury Bond Index. Since its 2008 debut, there’s been an average five percent gain in October for the ETF, a better return than any other month of the year.

One month, of course, doesn’t make a year.  But it should get fixed-income investors thinking about hedging their bond exposures, especially if principal preservation is a primary investment objective.

Interest rates are destined to head upward in earnest from their QE-induced quagmire. The only question is when. Will it be in this year’s fourth quarter? By mid-2015?  And with that in mind, is there a cheap and potentially long-lived hedge that can protect bondholders?

A rhetorical question, really. You know there is.

An effective hedge depends on leverage. After all, it makes little sense to invest large wads of cash to stave off comparatively modest losses. Take that ProShares TBT fund as an example. For a cash investor, a round lot cost over $5,300 at the beginning of October. Granted, you get twofold leverage, but you’re still laying out sizeable moolah. It’s certainly not futures-like hedging power. You can effectively lengthen the lever by buying the ETF on margin, but with a Reg. T requirement at 50 percent, you’d still need to plunk $2,600 into the trade. Still not cheap.

There are other, more highly levered options. Long-term options, known as LEAPS or Long-Term Equity Anticipation Securities, are calls and puts with maturities that can stretch out nearly two years. TBT call options that expire in January 2016 can be acquired for pocket change.

A call grants its owner the right, but not the obligation, to buy the underlying asset—in this case, 100 TBT shares—at a predetermined price at any time before the contract expires. Let’s look at some modestly priced calls.

A option is least costly when it’s out of the money; that is, when it isn’t presently worth exercising. With TBT trading $53.15, for example, a January 2016 call with a $60 exercise price was worth just $4.05 a share, or $405. At just eight percent of the current cost of a round lot, that’s leverage. Intrinsically, though, the call is worthless until TBT’s price rises above the call’s $60 strike price. The entire $405 premium represents the value of the time granted in the contract—the opportunity for the call to go into the money.

As TBT’s price fluctuates, so too will the call’s price. The object for the hedge isn’t ownership of TBT shares, but rather appreciation of the call’s market value if interest rates rise. The then-appreciated call can be sold for a profit, which hopefully offsets capital losses in the market value of bonds held in portfolio.

There’s a risk, though. There always is. If interest rates don’t budge or in fact drop, the call’s value can decline. If TBT’s price isn’t above $64.05—the breakeven price represented by the sum of the option’s strike and purchase prices—by January 2016, a loss will be sustained. The good news is that the loss is strictly limited to the $405 premium. No matter how far off-base your interest rate forecast, you can’t lose more than the initial cost of the hedge.

Of course, you’re asking TBT to rise 20 percent by the call’s expiry just to get your money back. Given the 24 percent annualized volatility in TBT’s prices, though, that’s not out of the question. In the last 12 months, TBT’s share price has swung from $81 to $53.

So let’s look at some hedge opportunities for a position held through January 2016:

Bottom line? The option hedge has considerably less risk than the ETF purchases, but requires countenance of a significantly higher breakeven point.

There is a way, however, to obtain a better breakeven. It’s a synthetic ETF or, more properly, a synthetic long futures position on the TBT fund. The strategy combines two LEAPS options:  a long call and a short put sharing the same strikes and expirations.

You could, for example, buy the January 2016 $60 call and simultaneously sell the January 2016 $60 put for a net credit (meaning you take in more premium than your payout):

Long Jan-16 $60 TBT call $  4.05/share

Short Jan-16 $60 TBT put $10.95/share

Net credit $  6.90/share

The margin requirement for the short put would be $2,158 (the sale proceeds plus 20 percent of the underlying ETF’s value). That’s partially offset by the net premium credit of $690, leaving you with an equity call of $1,468 to be satisfied by cash or securities in account.

So what do you get for all this?

Well, for one thing, open-ended gains as TBT’s value rises. That’s the same potential gain afforded by the outright call purchase. The breakeven’s very different, though. The synthetic position returns even money if, at expiration, TBT is just $53.10 (the $60 strike price less the initial $6.90 net credit). That’s a better breakeven than the outright ETF. 

And like the ETF purchase, the risk is open-ended. The worst-case scenario would be TBT falling to zero, resulting in an assignment (a requirement to buy the ETF) at the $60 put strike price. The call would be a total loss. In the end, you’d own TBT shares at the $53.10 breakeven price.

Ultimately, using a synthetic long TBT futures position allows you to defer purchasing a TBT round lot. In the worst case, you’re locking in today’s price (note that the breakeven price is within a nickel of the ETF’s current market value) and in the best case you either forgo the ETF purchase altogether or buy the shares at the $60 call strike price.

Of course, all this must be balanced against what’s happening on the bond portfolio side. If you’re at risk of being assigned on the short put, interest rates would have likely decreased, something salutary for your bond positions. On the other hand, your call moving deeply into the money means you’ve probably got countervailing value to offset the deleterious effect of rising rates.

Deciding whether—and how—to hedge your portfolio’s bond bets is a deeply personal matter and entails what my Dad would have called “horse sense.” Then, again, Dad was a fan of W.C. Fields, who once opined that horse sense is “the thing a horse has which keeps it from betting on people.” I don’t know of any horses who bet on bonds, either.