If You Think T-Bonds Are in a Bubble

01/29/2009 10:00 am EST

Focus: ETFS

Scott Burns

Director of ETF Analysis, Morningstar, Inc.

Scott Burns, Morningstar’s director of Exchange Traded Securities Analysis, says an ultrashort ETF can help risk-tolerant investors hedge against a selloff in Treasuries.

UltraShort Lehman 20+ Treasury ProShares (NYSEArca: TBT) is primarily a speculative satellite holding for investors with a strong belief that long-dated Treasury bonds will drop in value.

This ETF aims to provide investors with twice the daily inverse return of the same index that iShares Barclays 20+ Year Treasury Bond (NYSEArca: TLT) follows. The ETF tries to capture this return by taking positions in derivative instruments—typically swaps and future contracts.

Risk-averse investors can also deploy this ETF in moderation to offset any exposure they may already have to Treasury bonds through their broad market holdings. For example, 25% of iShares Barclays Aggregate Bond (NYSEArca: AGG) is allocated to Treasury bonds.

The market is essentially expecting almost no inflation over the next ten years, [so] the accepted real risk-free return is less than 2%. If you think that the US is going to experience deflation over the next few years, then a 2% return might seem reasonable. Opponents of this line of thinking would point out that the Treasury has been printing money at an alarming rate trying to reflate the economy and that eventually the bill will need to be paid in the form of inflation.

The dollar exchange rate and the Treasury rate are inexorably linked. If investors were to regain their risk appetite and start buying riskier assets in the US, such as stocks, corporate bonds, and real estate, then we could see Treasury rates rise as investors demand more and more return for their cash.

Still, I think that the important takeaway for anyone thinking that the Treasury market is in a bubble is to understand what will cause it to burst. Either the expectations for inflation will increase, the dollar will fall vis-à-vis other currencies, or investors will get their appetite for risk back. Of course, for those thinking about shorting Treasuries, the “when” becomes as important as the “why.” So, keep the timing of these events in mind as you make your bets.

We think the Treasury market is a little frothy right now—especially in the longer-dated tranches. But I won’t go so far as to say that it is a bubble ready to burst. We are still looking at falling asset prices for the next few quarters, and other countries are dealing with the same issues that plague the US. 

The leverage of this fund is not to be taken lightly, and the holding period needs to be short term. Leveraged and short ETFs—such as this—also [make] shareholders susceptible to large capital gains distributions from the funds.

Investors looking for short exposure to long-dated Treasuries, but without the leverage, can consider shorting TLT. Those looking for double-short Treasury exposure, but with a shorter duration, will want to look at UltraShort Lehman 7–10 Year Treasury ProShares (NYSEArca: PST). (TBT closed above $45 Wednesday—Editor.)

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