MARKETS CAN BE
like dominos: Rattle them long enough and they'll eventually topple over. Witness the past year, as investors have coped withdeclining equities
and aweakening dollar
Yet thanks to an aggressive Federal Reserve and a broad flight to quality, high-quality bonds have held up, with interest rates as measured by U.S. Treasurys pushed to historic lows.
Market evidence suggests that trend has begun to reverse, with the yield on the benchmark 10-year Treasury rising above 4% from 3.2% in mid-March. Although it's still too early for decisive confirmation, it increasingly appears as if the bond market could be the next shoe to drop, if it isn't already in the process of doing so.
Bear Market for Bonds?
10-Year Treasury Yield
Bond prices move inversely to interest rates. As bond prices fall, interest rates go up, meaning that shorting bonds is the equivalent of betting on higher rates. And for the individual investor, there are an increasing number of options for betting against bonds.
Open-ended inverse bond funds have been around a number of years. One of the best known is the Rydex Inverse Government Long Bond Strategy mutual fund, also known as the Juno Fund, which seeks to inversely correlate to the daily movement of long-term government bonds. Similarly, the ProFunds Rising Rate Opportunity bets on higher rates, but adds a bit of leverage to the mix: The fund seeks to achieve 125% the inverse price movement of long-term government bonds. Direxion also offers two open-ended fund that short bonds: 10 Year Note Bear 2.5x Fund and High Yield Bear Fund.
Although they offer the easiest and most simple option for getting exposure to higher interest rates, I'm put off by the lack of intraday liquidity and trading opportunity. The bond market is oftentimes even more volatile than the stock market, and the fact these funds can only trade at end-of-day prices limits their appeal.
Up until the introduction of the fixed-income ETFs I first profiled way back in 2002 it was nearly impossible for the average retail investor to directly short bonds without opening a futures account. The fixed-income ETFs changed that, giving investors of every stripe the ability to go long or short a variety of credit risks all along the yield curve, from short-term notes to long-term bonds. This opened up the opportunity to use strategies previously limited to large institutions.
For example, you can bet on improving credit spreads by buying
SPDR Lehman High Yield Bond
iShares Lehman 7-10 Year Treasury
Ameristock/Ryan 1 Year Treasury
SPDR Lehman Long Term Treasury
In this case, selling short bonds simply means selling short shares of whatever fixed-income ETF you feel is likely to fall the most. ETFconnect lists some 55 fixed-income options, from SPDR Lehman 1-3 Month T-Bill to Vanguard Long Term Bond ETF.
The newest option for betting on higher rates are also ETFs, although one need not sell them short to achieve the exposure. ProShares' new UltraShort Lehman 7-10 Year Treasury ETF and UltraShort Lehman 20+ Year Treasury ETF are the first funds to provide short exposure with a long position. Simply put, if rates go up, so do these funds.
Moreover, the funds are designed to provide twice the exposure, meaning that if the long bond falls 1.5% for the day, you could expect shares of TBT to rise by roughly 3%, accounting for some tracking error on the part of the managers.
The ETFs, which launched in the beginning of May, use cash to collateralize futures positions, which earns interest and will generate some modest income for investors. Both currently hold less than $100 million, but judging from asset growth and volume trends they are already starting to attract plenty of interest.
Of course, even a money-market mutual fund offers exposure to higher interest rates. You'll recall that it wasn't too long ago many money-market funds were yielding in excess of 4% vs. today's 2.4%. If current trends continue, we could eventually see a return to those levels.
Given the amount of uncertainty still present in the financial markets, there's always the possibility of a renewed flight to quality that could crush short bond positions. But this is one idea that big-picture players should most certainly have on their screens.
Jonathan Hoenig is managing member at Capitalistpig Hedge Fund LLC.>