A Great Hedge, Come What May

11/02/2011 11:00 am EST

Focus: ETFS

Whether it’s another US downgrade by credit agencies or an uptick in economic recovery, this ETF is a great hedge, writes Rick Pendergraft of Cabot Options Trader.

Back on August 5 after the market closed, Standard & Poor’s downgraded the United States debt rating from AAA to AA+. This was an important date for investors, because the S&P 500 dropped the following Monday and Tuesday, establishing the lower rail of the trading range we were in from the beginning of August until recently.

When the downgrade was announced, politicians were in an uproar. Republicans blamed President Obama and the Democrats for their spending. Meanwhile, the Democrats blamed Republicans and their insistence that taxes not be raised. Let’s face it, both parties are more a part of the problem than the answer.

Regardless of who and what were to blame, there are now rumblings that the US may be facing another downgrade.

The so-called "debt supercommittee" has a few weeks before they have to release their suggestions on how to get our budget under control. From what I’ve seen, they’re playing the same old games as before, and it’s unlikely that anything groundbreaking will come out of this brain trust.

Given that last statement, it wouldn’t surprise me to see another downgrade—and I wouldn’t blame the ratings agencies. What I am anxious to see is the reaction from investors if there is a second debt downgrade. After the August 5 downgrade, investors flocked to Treasuries as a defensive move.

The iShares Trust Barclay’s 20+ Year Treasury Fund (TLT) is an exchange traded fund (ETF) representing long-term Treasury bonds. The TLT jumped from around $105 on August 8 to the $125 level on October 4.

It’s not rational that investors were rushing into an investment that yields approximately 3.4%. Instead, investors were moving into Treasuries out of fear, and this sent the TLT on a huge two-month rally that saw the fund gain almost 20%.

Should Standard & Poor’s decide to lower the US rating from AA+ to AA, or should Moody’s or Fitch decide to lower their ratings on US credit, I would not count on a similar rush of buyers into Treasuries.

At the time of the first downgrade, investors were worried about far more than just the credit rating. There was the fear of the US dipping into another recession, the political wrangling over the debt ceiling in the US, and the ongoing debt problems in Europe.

If there is another downgrade, foreign investors may not view US Treasuries as the same safe haven they have considered it in the past. Foreign investors are the biggest buyers of US debt, and if they start shying away, bonds could start falling fast. When there is a lack of buyers, only sellers are left.

How can you benefit? With the ProShares UltraShort 20+ Year Treasury Fund (TBT), a double-inverse ETF that is the counterpart to the TLT.

TBT is designed to move up twice as much as the TLT moves down. In other words, if the TLT drops 15% from its current level, the TBT should rise 30%. (Full disclosure: I purchased the TBT for my investment management clients in early October.)

A move of this nature would erase the gain the TLT experienced from August until the beginning of October, and would move the TBT from the $21.50 level up to the $27.50 to $28 range.

A possible downgrade isn’t the only thing that would lift the TBT. If economic data continues to improve, we could see investors selling bonds and re-entering the stock market. Should inflation start to rise (the Producer Price Index jumped 0.8% in September), the Fed could start raising interest rates sooner than they had planned.

Any of these developments would cause selling in the bond market and would cause the TBT to jump, meaning that you would profit.

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