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The 5-year auction yesterday went over poorly. The US national debt continues to rise, and investors should include some kind of hedge against this as part of their portfolios. Here is how to make that kind of contingency plan.

Economic rationale

World governments have essentially socialized the private losses from the 2008 crisis and moved toxic assets onto the public balance sheets. Additionally, world governments have been expending an enormous amount of capital on stimulus projects. The private sector could get bailed out by the public sector, but the public sector does not have a lifeline; the only choices are default (very unlikely), drastic fiscal curbs (politically painful, so possible to some extent but not likely to a full extent), or monetization (likely, as is the inflation that comes with it). Therefore, as I have written in the past, there is an increasing risk with sovereign debt that investors need to monitor closely.

The market is starting to notice the rising national debt, and bonds for Warren Buffett's company now command a lower rate than US Treasuries over the same maturity period, according to Bloomberg.

Hedging against this will not make an investor rich, and in the short term, it could be a losing investment. It is, however, a prudent measure in case something bad does happen with worldwide sovereign debt.

There are a number of ways to do this kind of hedge. A number of ETFs are short US Treasuries, and options strategies can also be used. For the purpose of this article, T-bills, T-bonds, and T-notes will all be classified as “Treasuries”, since really, the only difference between them is the length of maturity.

ETF strategy

Buying the funds TBT or TMV could serve as a hedge against a national debt problem in the United States. TBT is 2-times levered and TMV is 3-times levered, so TMV is more aggressive. Both of these funds target long-term Treasuries, which I believe is the best strategy, since the government can likely monetize the debt in the short term—but must suffer inflation in the long term. Inflation results in higher yields, ergo, a weaker bond market—including Treasuries.

Option strategy

This strategy is more complex and probably not suitable for ordinary retail investors, but investors could consider buying out of the money puts on Treasuries. Out of the money options are cheaper, but they are a losing strategy until the market price of the targeted Treasury instrument drops below the strike price. Choosing the right strike price is critical, so this strategy is only recommended for advanced investors who understand the risks of using options.

Conclusion

Investors should include a hedge against turmoil in the Treasury market as part of a well-diversified, risk-balanced portfolio. The hedge does not need to be large, and perhaps should only be around 5 percent of a total portfolio. It could be a losing strategy in the short run, but if the US government starts having trouble financing its growing national debt, the hedge will help protect investors from the chaos that will ensue.

I also suggest you read my previous articles on the subject:

Disclosure: No positions

Source: Profiting From the National Debt