Banking & Finance

Bond Demise 2013: Has the Next Great Short Already Taken Off?

Just over one month ago we made the case that perhaps the best short since the heyday of the subprime mortgage debacle may be on the horizon. Our December 5 story identifying the biggest trade since the subprime short pointed out some inescapable facts about the longest rally ever in Treasury bonds.

The Treasury market has rallied for almost 30 years. Yields have ranged from Paul Volcker highs of more than 16% on the long bond and Fed funds at 21.5% to lows of 2.45% on the long bond and .18 basis points on Fed funds back in July of this year. Selling off back to the 16% level is all but impossible, but a move back up to a 4%, 5%, 6% or even 7% yield in Treasury notes and bonds is not out of the question. Again, the vexing question is when?

We asked when a month ago. Now we are asking whether it already has begun. On the day our story first appeared, the yield on the 30-year Treasury bond (TYX) closed at a 2.78%. Friday the yield hit an intraday high of 3.17%, a 14% increase, before finally closing at a 3.11%. That is a dramatic yield move in the bond markets.

Goldman Sachs Group Inc. (NYSE: GS) already is calling for higher Treasury yields, on top of the yield rise we have seen in recent days and weeks. With the 10-year yield around 1.935% now, the bulge-bracket firm and primary dealer sees the 10-year Treasury yield rising up to 2.00% to 2.25% in the near term. The question that must remain in the back of investors’ minds is whether this time really will be different. If the DJIA does rise more than 11% to our 14,590 peak target of 2013, will bonds still be as attractive? Very likely that answer is no.

So how does one put the trade on? Buying intermediate-dated TIPS, or Treasury inflation-protected securities, may be one idea. The logic is that rising interest rates will portend rising inflation, which will increase the value of the bonds. This may be the safest way to play the trade, especially owning TIPS that mature in 2019 or later.

Shorting the actual bonds, or an ETF like the iShares Barclays 20 Year+ Treasury (NYSEMKT: TLT) or Vanguard Long-Term Government Bond Index (NASDAQ: VGLT), may make sense. But when you are short bonds or interest-paying ETFs, you are responsible for paying the interest on the carry. This is in addition to the stock or bond loan cost. Short of a world disaster, the 2.45% low last July may very well be the bottom. But if this proves to be a head fake, the carry and loan cost could become expensive.

You can also purchase the leveraged short Treasury ETF, PROSHARES Ultrashort 20+ Treasury (NYSEMKT: TBT). While it certainly will provide you upside in a sustained Treasury sell-off, it has proven to be an inefficient vehicle that does not always accurately track rising yields.

One option strategy to consider is selling short the 55 strike TBT puts that expire in January of 2015 for $5.10 a contract and take in the cash proceeds. Each contract you sell will bring in $510 less commission. You are agreeing to buy the stock in January of 2015 or earlier at $55 per share, which is almost 18% below Friday’s price of $66.91. You can either keep your cash proceeds and hope the contract expires worthless or cover by buying the puts back if TBT trades higher. You also could use your proceeds to buy the TBT January 2015 90 strike call options at $5.10. Here you literally have two trades on the short. There is no cost to you except commissions, but you have to be willing to buy the stock if it trades at or below the 55 strike.

Shorting puts is a very aggressive strategy. It is not recommended for conservative investors or those unfamiliar with the option and derivative markets. However it may provide you with the most leverage to the trade at a cost lower than shorting actual ETFs or bonds. The risk-reward here is substantial, with the 30-year Treasury yield at less than half its long-term historical level. It may seem like a dangerous trade, but so was shorting the subprime market when real estate was booming.

Lee Jackson

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