A Better Way to Short Treasury Bonds Than TBT?

Includes: SBND, TBT, TMV
by: Nicholas Pardini

Shorting treasury bonds seems to one of the most sure bets out there. With rates at near-record lows, trillion dollar deficits, and rising inflation expectations, shorting treasuries should provide an excellent return. Due to the US government's current fiscal and monetary policy situation, there are only three possible outcomes: Lowering of the American government's credit worthiness, higher inflation, and/or the Fed increasing interest rates. All three scenarios are terrible for bond prices, and the probability of at least one of these three outcomes happening is near certain.

A common way investors try to profit off of declining bond prices is through leveraged short ETFs such as the TBT, TMV, or SBND, which double and triple the downward price movement of the bond each day. However, these instruments are crude at best because they fail to accurately track the long-term price of the bond. The ETF resets on a daily basis combined with the interest from the leverage creates in an inaccurate measure of the short's performance. The index that measures the changes of the 20-year Treasury yield has outperformed the TBT by 32%. Even on an absolute basis, while bond prices have significantly fallen. the TBT has actually lost 19% of its value over the past year.

So what can investors do to maximize profiting from higher bond yields and lower bond prices? Trade the way that the professionals do: Buy puts and short futures on long term treasury. Using a 30-year bond versus the 20-year on TBT creates larger price swings on interest rate changes. These strategies are not recommended for a beginning investor, but those who understand the futures and options markets can make more money from a more accurate decline in bonds.

The amount of leverage you use depends on how much capital you put in the above-margin requirement of the contract, so this strategy is also more flexible than buying an inverse ETF. I recommend buying longer-term options and futures. as the fundamentals for this trade have been evident since early 2009 (QE1 and stimulus-driven deficits), but fear in the marketplace and Bernanke's insistence on holding down rates have delayed the falling of long-term treasuries. Overall, shorting bonds in an excellent investment, but investors are better off doing it through long-term futures contracts or puts versus leveraged ETFs.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.