BEING STREET SMART
by Sy Harding
It's Time To Dump U.S. Treasury Bonds - Again!
December 2, 2011.
First let’s make sure we understand the basics of bonds.
Bonds are a form of debt. When a company or a government
needs to borrow money it can borrow from banks and pay interest on the loan, or
it can borrow from investors by issuing bonds and paying interest on the bonds.
One advantage of bonds to the borrower is that a bank will
usually require payments on the principle of the loan in addition to the
interest, so that the loan gradually gets paid off. Bonds allow the borrower to
only pay the interest, while having the use of the entire amount of the loan
until the bond matures in 20 or 30 years (when the entire amount must be
returned at maturity).
Two main factors determine the interest rate the bonds will
yield.
If demand for the bonds is high, issuers will not have to pay
as high a yield to entice enough investors to buy the offering. If demand is low
they will have to pay higher yields to attract investors.
The other influence on yields is risk. Just as a poor credit
risk has to pay banks a higher interest rate on loans, so a company or
government that is a poor credit risk has to pay a higher yield on its bonds in
order to entice investors to buy them.
A factor that surveys show many investors do not understand,
is that bond prices move opposite to their yields. That is, when yields rise the
price or value of bonds declines, and in the other direction, when yields are
falling, bond prices rise.
Why is that?
Consider an investor owning a 30-year bond bought several
years ago when bonds were paying 6% yields. He wants to sell the bond rather
than hold it to maturity. Say that yields on new bonds have fallen to 3%.
Investors would obviously be willing to pay considerably more for his bond than
for a new bond issue in order to get the higher interest rate. So as yields for
new bonds decline the prices of existing bonds go up. In the other direction,
bonds bought when their yields are low will see their value in the market
decline if yields begin to rise, because investors will pay less for them than
for the new bonds that will give them a higher yield.
Prices of U.S. Treasury bonds have been particularly volatile
over the last three years. Demand for them as a safe haven has surged up in
periods when the stock market declined, or when the eurozone debt crisis
periodically moved back into the headlines. And demand for bonds has dropped off
in periods when the stock market was in rally mode, or it appeared that the
eurozone debt crisis had been kicked down the road by new efforts to bring it
under control.
Meanwhile, in the background the U.S. Federal Reserve has
affected bond yields and prices with its QE2 and ‘operation twist’ efforts to
hold interest rates at historic lows.
As a result of the frequently changing conditions and
safe-haven demand, bonds have provided as much opportunity for gains and losses
as the stock market, if not more.
For instance, just since mid-2008, bond etf’s holding 20-year
U.S. treasury bonds have experienced four rallies in which they gained as much
as 40.4%. The smallest rally produced a gain of 13.1%.
But they were not buy and hold type situations. Each lasted
only from 4 to 8 months, and then the gains were completely taken away in
corrections in which bond prices plunged back to their previous lows.
Most recently, the decline in the stock market during the
summer months, followed by the re-appearance of the eurozone debt crisis, has
had demand for U.S. Treasury bonds soaring again as a safe haven.
The result is that bond prices are again spiked up to
overbought levels, for instance above their 30-week moving averages, where they
are at high risk again of serious correction. In fact they are already
struggling, with a potential
double-top forming at the long-term significant resistance level at their late
2008 high.
Here are some reasons, in addition to the technical condition
shown on the charts, to expect a significant correction in the price of bonds.
The current rally has lasted about as long as previous
rallies did, even during the 2008 financial meltdown. Bond yields are at
historic low levels with very little room to move lower. The stock market in its
favorable season, and in a new leg up after its significant summer correction.
Unprecedented efforts are underway in Europe to bring the eurozone debt crisis
under control. And this week those efforts were joined by supportive coordinated
efforts by major global central banks that are likely to bring relief by at
least kicking the crisis down the road.
Holdings designed to move opposite to the direction of bonds
and therefore produce profits in bond corrections, include the ProShares Short
7-10yr bond etf, symbol TBX, and ProShares Short 20-yr bond, symbol TBF. For
those wanting to take the additional risk, there are inverse bond etfs leveraged
two to one, including ProShares UltraShort 20-yr treasuries, symbol TBT, and
UltraShort 7-10 yr treasuries, symbol TBZ, designed to move twice as much in the
opposite direction to bonds. And even triple-leveraged inverse etf’s including
the Direxion 20+-yr treasury Bear 3x etf, symbol TMV, and Direxion Daily 7-10
Treasury Bear 3X, symbol TYO.
In the interest of full disclosure, I and my subscribers have
positions in one or more of these ‘inverse’ bond etfs.
Editors: You are welcome to quote from this article, or use it in its entirety, in your publication or on your website, as long as the credit in the above paragraph is also included. Readers are also welcome to e-mail, or print and snail-mail it to friends.
These reports reflect our opinions and are based on our best judgment, but no warranty is given or implied as to their accuracy. Past performance does not guarantee future performance.
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Asset Management Research Corp. -- ALL RIGHTS RESERVED.