Treasury Bonds Flirt With Bear Market

 | Oct 10, 2013 | 11:30 AM EDT
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I was having Chipotle Tuesday night with a friend of mine, a guy who by his own admission is really bad with money.

He was telling me a story about how his mother, a reasonably prosperous hospital administrator, got rinsed in the 2008 financial crisis and panicked her entire portfolio into bonds. She did so because as everyone knows, bonds are safe. His point was that his financial illiteracy was hereditary.

To even marginally-financially literate people, we immediately know this to be a bad trade, because stocks went on to recover all of their losses and then some. But in my estimation, it will get worse, because I think it is pretty obvious that U.S. Treasury bonds have entered a bear market, the very early stages of one.

The first myth I'd like to puncture is that bonds are safe: people found this out the hard way when they were down almost a smooth 10% on their newly-issued AAPL bonds just on interest rates alone. As a rule of thumb, the duration of a bond represents the approximate percentage change in price for a 100 basis point move in interest rates. Since the duration of the on-the-run Treasury is about 19, if rates go from 3.6% to 4.6%, if you own one, you will lose 19% of your investment.

Well, that is what happens when you have very low coupons -- it lengthens the duration of fixed income securities, making them more volatile. I would argue that there are millions upon millions of investors just like my friend's mom. They are hiding out in bonds because stocks are "risky", writing $250 checks to the PIMCO Total Return Fund, without realizing that even a tiny change in rates could wipe out a fifth of their investment.

It's not terribly original thinking to say that interest rates are going to rise. But the fact that most retail investors think that treasuries are safe, juxtaposed with what could be a missed coupon payment and technical default by the U.S. government is just astounding. The fact is that the United States of America is a terrible credit precisely because our political process is dysfunctional. And if anything, S&P's downgrade two years ago under predicted exactly how dysfunctional it would become.

 I'm actually not of the opinion that interest rates would shoot up in the event of a technical default -- I think most international investors will continue to view U.S. debt as money good, unless the impasse shows no signs of ending. But interest rates are making higher highs and higher lows, which means that I am only interested in trading bonds from the short side.

Shorting actual bonds is impractical for a lot of people, for obvious reasons. Bond futures are okay, but the cheapest-to-deliver contract has a much shorter duration than the on-the-run issue. And futures aren't just for anybody, anyway.

It can be accomplished through ETFs, but most people choose the wrong one. Many people are enamored of leveraged ETFs, and ProShares UltraShort 20+ Year Treasury (TBT), the leveraged inverse bond ETF, is pretty popular. But the mathematics of leveraged ETFs ensures that the value of your investment will decline the longer you hold the fund. Years after the introduction of leveraged ETFs, that is a point still not well understood.

My preferred vehicle for shorting bonds is the iPath US Treasury Long Bond Bear ETN (DLBS).The fund holds a short position in bond futures such that for every basis point move in bond yields, the value of the fund will change by .10. The ETF is engineered such that it takes a convex instrument and turns it into a linear payoff that's easy to trade and simple to understand.

I don't currently own DLBS, but I have in the past, and I probably will again should 30-year yields get down to about 2.25 percent. The investing public has massive interest rate exposure at the point where our willingness to meet our obligations is in question. Something doesn't seem right here.

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