Banking & Finance

A How-To Guide for Betting Against Treasuries, Bracing for Higher Interest Rates

Is the Treasury market finally living up to its threat as the next big short? The money that was made in the period from 2007 to 2009 on the subprime mortgage short provided some of the most staggering profits ever realized. Treasury yields have hit new 2013 highs on the 10-year note, and the day of reckoning may have finally arrived after a 30-year secular bull market. Yields in 1982 hit highs of about 16%, with the 30-year breaching 2.50% in 2012. Selling off back to the 16% level would seem to be next to impossible, but a move back up to a 4%, 5% or even 6% in Treasury notes and bonds is possible.

Federal Reserve Chairman Ben Bernanke has pledged to keep rates low until as late as 2015, although this has been under debate for weeks now as more Fed presidents have hinted that some quantitative easing methods could be tapered off gradually and sooner than originally expected. The mere mention of such a process, along with slightly better economic reports and a strong stock market, already has sent the bond market reeling in the past week, with the 10-year and 30-year Treasury yields hitting the highest yields in a year.

So how does one actually bet against Treasury notes and bonds or make money from rising interest rates?

Buying intermediate dated TIPS, or Treasury Inflation-Protected Securities, may be one idea, even if we just saw a TIPS auction still go off with a negative yield in the past week. The logic is that rising interest rates may signal rising inflation, which will increase the value of the adjustable rate bonds. This may be the safest way to play the trade, especially owning TIPS that mature in 2019 or later. One exchange-traded product here on this is the iShares Barclays TIPS Bond (NYSEMKT: TIP).

Short selling the actual bonds or an exchange traded fund (ETF) like the iShares Barclays 20-Year+ Treasury (NYSEMKT: TLT) or the Vanguard Long-Term Government Bond Index (NASDAQ: VGLT) is another avenue. By shorting the actual securities, you are responsible to pay the coupon of the bond. Be advised that if you are short long-dated Treasuries, you will not want to be around if we get another financial panic and the flight to quality pushed bond yields back down.

You can also purchase the short Treasury ETF, PROSHARES Ultrashort 20+ Treasury (NYSEMKT: TBT). It is supposed to rise in value as long-term rates rise. Unfortunately, it has proven to be at times a very inefficient vehicle that does not always accurately track rising yields. It can face tracking errors and does not capture much of the moves in interest rates if those moves occur when the liquid markets are not open.

There is also a more aggressive way to trade the TBT where prices are now. You can sell short the $56 strike TBT January 2014 put options and take in the cash proceeds. You do not have to pay the carry of actually shorting the bonds, and you are more than 15% below the current TBT price. The $56 strike price is where you would have shares put to you and is below where the TBT traded last summer when yields hit their low.

We have featured how rising rates pose a threat to your investments. Rising rates are putting pressure on key utility stocks with their dividend yields of 3%, 4% or even 5%. The other huge risk in rising rates is seen is mortgage REITs with their high double-digit yields. Credit Suisse once put out a list of MLPs that would also survive rising rates, but that may need a refresh.

Bill Gross of PIMCO has warned that the outperforming nature of bonds has likely run its course and that coincided with an awful two-year Treasury auction this week. In fact, he recently said that the bond bull market probably ended on April 29. It suddenly starts to make more sense that the 30-year Treasury bond is approaching a 3.30% yield and that the 10-year yield is approaching 2.20%. If you have big gains in your portfolio on government bonds, the time to take profits may be at hand.

We have been featuring the rising interest rate risks and will continue featuring this for your personal finances. Your money matters to those of us at 24/7 Wall St.