The Global Guru: Is This the Trade of the Decade?

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Nicholas Vardy, CFA
Editor, The Global Guru

Even as investors are focused on the recent rally in the U.S. and global equity markets, they have all but ignored tumbling U.S. Treasury and bond prices.

But with more than a $1 trillion going into bond exchange-traded funds (ETFs) and mutual funds during the past two years -- and many investors taking money out of the stock market -- the fall in bond prices could have a much greater impact on your financial future than the recent stock market rally.

Chances are most retail investors don't quite understand the losses they could suffer in "safe" bond investments as a result of the "good news" of economic recovery and as interest rates start to rise.

On the one hand, one of the benefits of the central banks' money printing bonanza is that they have kept interest rates low for borrowers.

On the other, by keeping interests rates low, they have also created a ticking time bomb for bond market investors.

Long-time market hands will remember that many hedge fund managers had their heads handed to them in 1994 when the Fed began to raise interest rates unexpectedly.

And that turned out to be a mere blip in a 30-plus year bull market in bonds.

If the last two months are, indeed, the start of the "Great Rotation" -- a shift from bonds back to stocks -- it could also mark the start of a trade that could make you more money over the next decade than betting on your favorite stocks ever could.

The Tyranny of Bond Math

With terms like "duration" and "convexity," bond math is kind of hard to get your head around.

The gist is this. At low interest rates like we have today, any rise in interest rates is a much bigger danger to your bond investments than you think.

First, a rise in low interest rates increases bond duration, as a larger portion of the value of the bond is the lump sum due when the bond matures.

Put another way, if you're getting 12% a year from your investment -- roughly 1% per month -- you're less worried about its underlying price than if you're getting only 1% per year.

That's why low interest rates and longer durations make bond prices much more volatile.

Second, "convexity" tells you that the starting interest rate before an interest rise matters a lot more than you probably think.

Whether interest rates from 1% to 2% or from 10% to 11%, it's only a 1% absolute move in both cases.

But the 1% move between 1% and 2% doubles your interest rates, while the same move of 1% from 10% to 11% is only a 10% increase in rates.

The underlying price of your 1% yielding bond will get hit a lot harder if rates double to 2% -- versus a 1% move if rates were at 10%.

Here is an example.

According to a recent calculation made by the Wall Street Journal, U.S. Treasuries yielded 1.95% on Friday.

If yields were to double to 4%, investors would see the price of that Treasury bond fall from $97.15 to about $81 -- a drop of more than 16%.

So much for viewing bonds as a "safe" investment.

When Will The Bond Bubble Pop?

My uncle in Florida-- a now-retired physician to some of the best-known teams in sports -- once told me that over the course of his long career, he never invested in anything but U.S. Treasury bonds.

And if you look at the chart below tracing the remarkable fall in interest rates over the course of his career, he's been remarkably right.

 

After all, interest rates have been falling for over 30 years.

Today, low interest rates seem as natural as the sun rising in the East and setting in the West. And as an investment, U.S. Treasury bonds have been a one way bet.

That's what has me worried.

The "trend is your friend" -- until one day it isn't.

And given how far interest rates have fallen, there is a heck of a lot more room for rates to rise than to fall.

Once the trends turns -- and rates do start going up -- as they have in the past month or so, look out below.

And when, not if, the bull market in bonds ends, it will happen quickly.

In stock markets, they say "the bull goes up the stairs and the bear goes out the window."

The same applies to the bull market in bonds.

And thanks to the "tyranny of bond math," a bear market in bonds could be even more devastating.

A lot of investors who thought they were in safe investments are going to get hit very hard, very quickly.

How You Can Profit

The favorite vehicle for retail U.S. Treasury bears is a short position in U.S. Treasuries through the ProShares UltraShort 20+ Year Treasury (TBT).

Note that over the last six months, it has outperformed an investment in the U.S. S&P 500 -- though at the cost of substantially more volatility.

 

So is this the time to bet against U.S. Treasuries?

It's probably too early to tell.

But just like all other bull markets that were never supposed to end -- say, the Japanese stock market and U.S. housing -- this one will end one day, too.

And if you do get your timing right, betting against U.S. Treasuries just might turn out to be your "trade of the decade."

To read my e-letter from last week’s Eagle Daily Investor, please click here. I also invite you to comment about my Eagle Daily Investorcolumn in the space provided below.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: News Headlines , US Markets , Bonds , Mutual Funds

Referenced Stocks: TBT

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