Sunday, November 2, 2008 4 comments ++[ CLICK TO COMMENT ]++

Is It Time To Start Getting Bearish...On US Government Debt?

It's time to start getting bearish. What's a contrarian to do given that almost everyone is bearish on everything, including stocks, bonds, commodities, and real estate? Well, being contrarian for contrarian-sake is dangerous but it does avoid getting involved in bubbles. So what's everyone bullish on these days? What's everyone tripping over for these days?

One needs to look no further than the US government bonds.

Check out the following summary of US government bond yields from Bloomberg:

Horrifying stuff. If you are an investor that is. Six month T-bills with a yield of 0.98%. Thirty year bonds at 4.33%. Of the "safe investments," buying a 30 year bond at a yield around 4% is probably one of the riskiest deals out there. Of course the market doesn't agree with my thoughts.

So is it time to make a bear call on US government bonds? The following chart from Yahoo Finance is the 10 year yield over the last 40 or so years:

One must be a daredevil to go long the 10 year bonds, let alone the 30 year bonds. Does it look like yields have more room to drop? I would say it is almost a certainty that yields will go up. The only way it can go down is if we get massive deflation. Although that's what most investors seem to be thinking these days, I think the likelihood is pretty low. As Jim Grant has said several times, nominal GDP dropped almost 50% within 4 years during the Great Depression, while real GDP dropped slightly over 25%. The latest numbers point to no such trend. If one wants to hear some superbearish arguments, you can check out a couple of free samples that Jim Grant has made available (these are likely temporary and may dissapear in the future): Gold 36,000 and Bearish on the biggest monoline.

Having said all that, I think betting against US Treasuries is not very attractive to small investors. It's better to go long gold or invest in equities that may benefit from rising interst rates. One problem is that short positions or inverse ETFs have to cover the interest payment. Paying almost 4% interest while waiting for bond prices to collapse may end up being expensive. Secondly, the upside is quite low. This can be such a long, drawn-out, process that your annual returns may be well under 10%. Lastly, if you are a foreigner, currency moves make bond bets very risky (unless you can hedge them.) I remember taking a long position in US Treasuries a few years ago and ended up selling with something like -7% in Canadian dollars (while it was around +10% in US$) :(

So, even if one turns bearish on US government debt, it's better to adjust your portfolio to prevent damage, rather than going on the offensive and trying to bet against US government bonds. Even if you don't care about bonds, it's important to remember that the market will re-price stocks downward if interest rates rise. In other words, if the discount rate goes up, asset values will decline. It's important to remember that the massive bull market in stocks in the 80's and 90's was mainly due to declining bond yields.

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4 Response to Is It Time To Start Getting Bearish...On US Government Debt?

November 2, 2008 at 8:04 PM

What is wrong with using TBT (Ultrashort 20+ year treasury) to bet against the long bond? I am of the mind that the yield on the long bond will reverse dramatically in less than three years, and this vehicle avoids the interest payment problem.

November 3, 2008 at 3:07 PM

I'm not familiar with TBT. Someone will still have to pay the interest so is it covered somehow by the ETF (some inverse ETFs hold cash to cover such payments while taking positions in derivatives)?

What's your definition of reverse "dramatically"? If we are talking about, say, 25% over 3 years, that's only around 8% per year (ignore compounding). That's without the interest payment that may have to be covered one way or another. This wouldn't be very attractive in my opinion (unless you think this is a low risk bet.)

If we roughly assume a 20 year bond moves 20% for each 1% change in interest rates, how likely is it for long rates to change 2% or more within 3 years (in order to produce returns of 20% or more)? If you look at the long term 10 year chart, it takes 5 to 10 years for the yield to move 2%. For 20 year bond, it would be quicker (say 3 yrs to 8 yrs) but it's still not certain. So during a normal scenario the short position will only be marginally attractive.

However, if you are superbearish and think yields can skyrocket (say due to high inflation) then your returns will be more than adequate. But it's difficult to see inflation being very high. I think inflation will be higher, but not very high.

November 3, 2008 at 5:54 PM

TBT holds t-bills and is short futures and swaps to achieve the desired effect. When I say dramatically, I mean I think yields will rise to the 12% range. It's not just a matter of inflation; our credit worthiness will come into question sooner rather than later, and we will be forced to pay higher yields to attract lenders. Were rates to rise from the current ~4% to 12%, each 1% move would cause a 40% up move in TBT, and since the leverage is daily and I expect the upward movement to be something approaching monotonic when the stuff hits the fan, the return would be something closer to (1.4)^8, or even better, depending on the size and speed of the moves. Over five years, that comes out to over 70% per year, and I think it will take less time than that.

November 3, 2008 at 7:18 PM

You are definitely expecting something drastically worse than I am. I just don't see 12% yields on the horizon. My expectation is more like 6% or 7% over several years (from the current 4%)...

Anyway, Jim Rogers is long TBT and short TLT. So you have some good company :)

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