The Right Way to Short U.S. Treasury Bonds

by: Keith Fitz-Gerald

Although we're in the midst of a U.S. Treasury bond bubble so big that pundits are calling for investors to short the government paper, resist the urge to jump in with both feet.

Doing so right now is nothing more than a "widow-maker" trade that will test both your patience and your pocket book. And yet, "shorting" the U.S. Treasury bond market is an opportunity you can't afford to pass up - so long as you execute the trade correctly.

A T-Bond Backgrounder

U.S. Treasuries have risen an average of 2.9% this year while the Dow Jones Industrial Average has dropped 2% and the Standard & Poor's 500 Index has declined 3% - and that's after the best two-day run for stocks since July.

In case you're not familiar with how yields and Treasuries work, here's the 10-second version. The first thing to understand is that bond prices and bond yields move in opposite directions.

So when you hear pundits say that Treasury bond yields are falling, you should immediately understand that Treasury bond prices are rising. Conversely, if you hear that Treasury prices are falling, you know that Treasury yields - the rate you're being paid to hold them - are rising.

Generally speaking, if you buy bonds for less than $100 in face value, you can expect to get back your principal - plus interest. But if you pay $102, for example, you are paying more than the principal value of the bond. The upshot: When that principal is returned, you're going to get $2 less back than you paid out.

When you express this shortfall in terms of Big Macs, Red Bull, or a steak at Outback, you're simply paying more money than the meal is worth. When it comes to bonds, what this really means is that you are incurring an actual loss for the mere privilege of investing in "safety."

You and I both know that making an investment where you are practically guaranteed a loss makes no sense at all. And yet, that's precisely what millions of panicked investors are doing right now. Just look at the 10-year U.S. Treasury note. Investors have bid up the 10-year note so much that the yield has been driven down to a piddling 2.625%.

At this point in time, the yield is so low and investors are willing to pay so much for "safety" that they're looking at a "doubling period" of roughly 27 years.

That's certainly nothing to write home about. But that's what passes for safety these days.

So if you can't beat ‘em, do you join ‘em - and pile into Treasuries on the assumption (blind hope?) that the bonds will go higher, still?

Candidly speaking - that's a tough call.

Two Outlooks for Treasury Prices

On one hand, the uncertainty-stoking bad news just doesn't seem to stop - and that uncertainty is what's fueling the rush to "safe-haven" U.S. Treasuries.

Fears of a "double-dip" recession are intensifying, pundits are predicting another downward spike in housing, picky consumers are forcing already-exasperated retailers to discount even more, and there's no borrowing to speak of taking place.

Then there's deflation - the risk that prices for goods and services could actually decrease, the scenario many econo-wonks next expect to see. In a deflationary economy, U.S. Treasuries would also move higher as investors seek the relative safety of government paper when the U.S. basically turns into Japan and meanders its way through a "Lost Decade" - or "Lost Decades" - as the case may be.

These are all catalysts for higher Treasury prices.

On the bearish side, I see a bond market that's being propped up - albeit with misguided policies - to the tune of $12.4 trillion, and a government that has indicated its willingness to remain "accommodative" for as long as it takes. When sentiment changes, that will lead to lower bond prices.

Then there are all the U.S. companies enjoying banner results. According to Bloomberg, "more than 75% of the companies in the S&P 500 that reported second-quarter profits exceeded the average analyst estimate since July 12."

This, too, speaks to higher yields and lower bond prices: Because investors dump bonds to buy stocks, bond prices typically fall during high-growth periods. And, as just mentioned, a decline in bond prices leads to an increase in yields.

Bloomberg also reported that S&P 500 companies are expected to see earnings rise 36% this year. That, too, should send money out of bonds and into stocks at a torrid pace, causing Treasury prices to fall - if for no other reason than investors shouldn't "want" them.

So why do I believe bond prices could still have room to run?

My own belief is that there is still enough panic in the marketplace and still too much liquidity. I believe that the vast majority of companies are making money based on nothing more than financial engineering and cost-cutting, rather than healthy top-line growth.

I also believe that the bulk of the recovery courtesy of our government is completely fabricated with very little to back it up in reality. In my mind, no amount of cheerleading from Washington is going to make consumers spend money they don't have, or take on the big debt loads needed to buy new cars and new houses (two ways to jump-start an ailing economy) - even if rates go all the way to zero.

I base that insight on my firsthand observations of Japan, where I've spent portions of each of the last 20 years. Rates there literally did go to zero and nothing changed. That country is now on its tenth stimulus, and its leaders are still arguing about how to restart the economy's heart.

Walking the Tightrope on Treasuries

At the end of the day, I believe that we could actually see yields on the 10-year Treasury fall below 2% - and perhaps even reach 1% - before the inevitable day of reckoning arrives. And when that reckoning occurs, the bubble will burst with a force that will make the "dot-bomb" Internet-stock implosion seem positively tame by comparison.

I'm not alone in predicting this scenario: It's precisely this expectation that's inducing so many professional investors to short Treasuries, with predictable carnage, given the strong bond-market performance. That's what's making this trade a "widow-maker" for anyone who's tried it so far - including me.

At the same time, despite the lack of luck investors have had shorting Treasuries, I'm not anxious to go long and pony up more than $100 for 10-year notes; I just don't like a trade that makes it possible - if not probable - to lose money from the get-go. So even though guys like Avi Tiomkin, chief investment officer at Tigris Financial Group Ltd., and Van R. Hoisington, head of the Austin-based Hoisington Investment Management Co., still favor buying U.S. government paper, I'll pass.

So what's the answer?

Shorting Treasuries is the play - but there's a right way to do it in order to capitalize on this very impressive profit opportunity. My advice is to average in on such specialized inverse bond funds as the ProFunds Rising Rates Opportunity Investment Fund - whose holders are likely to profit handsomely when bonds ultimately do reverse.

I should also note that - given the uncertainty that seems to be building - I don't care if I'm a bit early: I'm confident the bond-market reversal will come. My advice to move with caution is due to the fact that I don't know precisely when.

Nor do I particularly care. The opportunity is a big one. And this decision to invest in an eventual U.S. Treasury bond market reversal meshes well with the broad investment strategy I've sketched out over time.

In the meantime, until the Treasury market does reverse course, you'll be able to find me at the hors d'œuvre table, snacking on the opportunities that I find while I wait.