Your Long-Term Risk Vs. Reward Investment For 2013

Includes: TBF, TBT, TMV
by: JAR Financial Management

The one negative in regards to being an investor is that at every family event you will always get one question, "What hot stock do you recommend owning?" This Christmas was no different, but this year my best long-term investment is not a particular company or a specific industry (by "best" I mean greatest return for the level of risk). My "best" long-term investment this year is often described as shorting treasury bonds or going long interest rates. In order to understand why, I must rewind a few years and explain something I have yet to hear any analyst or television anchor speak of.

Ask people on the street what caused the housing crisis of 2008 and you will receive a hundred differing opinions. Here is news you might not know… they are all wrong. 2008 was a mere continuation of a housing crisis started in 2007. Yes, prices began to drop in 2007 and accelerated in 2008. It is important to understand why it accelerated in 2008 in order to understand my investment thesis for the coming year.

Individuals tend not to take action until something detrimental happens to themselves. In June 2007, I told a friend of mine who owned a mortgage brokerage firm it would be a good idea to start looking into doing something different because in 2008 reality was going to hit many people. His response was that the coming recession would be quick and rebound even quicker. I told him not to get his hopes up because I believed we wouldn't have any meaningful rebound until 2013 at the earliest. So why 2013? When home prices started declining in 2007 it didn't affect many people. Take myself for example, I live in Silicon Valley and if you told people around here about housing price decreases, they would say you were crazy. However, as cities that were affected by housing price decreases moved closer to main population hubs such as Silicon Valley, individuals began to take notice. Then reality hit for many in 2008.

To explain this reality, I will provide an example. If I bought my house in 2003 using an interest only 5/1 adjustable rate loan (this means the rate is fixed the first five years, then goes adjustable), I would have been paying around 3.5% on my loan. On a $300,000 loan, this is $10,500 a year. In 2007, when I am told of the housing market declining, I don't change any of my habits. Why should I? I still have my job, my mortgage is only $10,500 a year and I live by the age-old saying "it can't happen to me." Then one afternoon in January 2008, I open up my mortgage bill and to my surprise my interest rate went from 3.5% to 7.5% or $22,500, an increase of $12,500 (Fed rate at this time was 4.25%, many loans such as option arms had a larger increase in payments). As I read this, I am still not affected because I can go to the bank and refinance. I get to the bank where they apologize and tell me they can't refinance my loan because I am upside down on the property. This is when reality hits that I'm going to be $12,500 poorer each year or I'm going to get foreclosed on. Either way, I need to tighten spending.

This example happened to millions of homeowners. This reality led to mortgage defaults which led to credit tightening which led to less spending and so on and so on until it affected virtually every corner of the market from October 2008 to April 2009. So what made me say there would be no rebound (specifically any meaningful rise in interest rates) until 2013 at the earliest? Ben Bernanke and company are aware that we live in a consumer-driven country. Take money out of the consumer's hands and an economic slowdown will occur. The last 5/1 adjustable rate mortgage was written in 2007, which means it's due to go adjustable this year in 2012. Not only that, but in my opinion, Mr. Bernanke has kept rates low because many homeowners that purchased 2/1 and 3/1 adjustable rate loans still have not been able to refinance them because their homes are underwater (I should clarify that I believe this is one of the major contributing factors of keeping rates low, not the only one). By keeping rates low, he keeps housing affordable for these individuals. Since these adjustable rate homeowners have low payments now, their reality has changed back to "everything is fine" and they have resumed spending which is one reason why I believe consumer spending has risen over the past three years. The Fed realizes that if rates rise too quickly, then reality will set back in for these homeowners and the economy faces another real recession. I believe this has been a major contributing factor for the 0% interest rate policy for the past four years and a major contributor to our "fragile" economy.

I do not believe we will see raising interest rates until 2014 at the earliest and we won't see any drastic rise in interest rates until 2016. I believe this because the housing price index is currently at -15.37% below the level it was in September 2007, which is around the time the last adjustable rate loans were being written. This currently makes refinancing difficult and government refinancing programs will take time to work (if they work at all). Currently, Fannie Mae has $19.23bn of adjustable rate loans on their balance sheets or 7.05% of their total single family loan portfolio. It will take a few more years until these loans decrease to a point where defaults/foreclosures would have a minimal effect on the housing market and have a minimal effect on what I have termed consumer "reality." I stated earlier that my investment thesis for 2013 was to go long interest rates or short treasuries. I've been asked why I don't wait till 2014 to which I respond, "you can't time the market." In September 2004, while I was in college, I recommended to my father to buy gold then at $405 an ounce. This was based on a study we did and how long the Fed had kept rates down. I told him I didn't know when but I felt gold would at least double within seven years. Since I was in college, I decided to wait because I could not afford to have my funds tied up for that long. Waiting obviously cost me. I feel that I am facing the same situation now in regards to interest rates and that's why I recommend going long interest rates (short bonds). I believe the current reward is far greater than the current risk.

Investment recommendation

Begin to build a long-term position in interest rates or by shorting bonds. It is true that interest rates on short-term bonds are more volatile than rates on long-term bonds. However, long-term bond prices are more volatile than short-term bonds, so I will be shorting long-term bonds (this is a result of duration, I am also referring to treasuries). I also want to focus on three long-term outcomes for interest rates; they go down, stay the same, or go up. The reason why I state there is low risk in this investment because there is not much room for rates to drop. Some analysts say we will be the new Japan where we have the same low interest rates for decades, others say we will go up. I will demonstrate how to position yourself for both of these scenarios and allow you to decide what you think is going to happen with rates over the next five to ten years.

The first way to short bonds is also the hardest for retail investors. If you have the means, you would short long-term treasury bond futures and continually roll them at expiration. If you believe rates will stay down for the foreseeable future, we can sell puts and collect the premiums to enhance your holding period returns and provide some downside protection.

The second way to short bonds is via ETF. There are three ETFs that short long-term treasury bonds, ProShares Short 20+ Year Treasury (NYSEARCA:TBF), Proshares Ultrashort 20+ Year Treasury (NYSEARCA:TBT), and Direxion Daily 20+ Year Treasury Bear 3x shares (NYSEARCA:TMV). The difference between the three is based on volatility (risk) and expected return. TBF is expected to be the least volatile followed by TBT, then TMV. The highest expected return comes from TMV followed by TBT, then TBF. If you believe rates will remain stagnant for years to come, then you may sell covered calls if you hold these ETFs. For example, TBT currently trades at $62.46. A March call with a strike of $66 currently sells for $1.67. By March, if the stock is at or above $66 you would make $5.21 or 8.34%. If you believe interest rates will eventually rise and are investing for the long term, simply buy and hold. For any of these purchases, I do not recommend buying all at once. Determine how much you want to contribute to shorting bonds and develop a plan throughout 2013 to implement your strategy.

Disclosure: I am long TBT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.