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Worried About the Growth of U.S. Debt? Here's How to Profit

Treasury

by John Jagerson, analyst at Learning Markets | July 29, 2010

Are you worried about a collapse in the U.S. Treasury bubble? This article will review a new product in the market that can be used to turn that fear into a profitable opportunity. Specifically, we will be reviewing the Powershares 3X 25+ Treasury Bond ETNs. These are leveraged investments and in general it is safe to assume that leveraged and inverse ETNs and ETFs are a mixed bag of benefits and significant disadvantages. They offer very convenient access to markets and strategies that would be very difficult or inefficient for individual traders but they have to be used correctly or they can be real trouble for small traders. We will also be digging in a little deeper into these instruments during today's 'ask the expert' webinar so make sure you register for that event below.

Aggressive traders like these ETNs because they offer a way to profit from a likely future disruption in the U.S. Treasury market asset bubble. Asset bubbles tend to move from one series of investment-classes to others in an endless game of whack-a-mole. For example, over the last decade, the asset bubble in U.S. tech stocks and Asian land markets popped in the late 90's and early 2000's, then moved to real estate and emerging markets over the next 8 years, popped again in 2008 and migrated to the U.S. Treasuries bond market where we have the bubble we are currently watching. This bubble-to-bubble migration is endless and was one of the things Wade Hansen and I wrote about in our book (Profiting with Forex - McGraw Hill 2006).

Bubbles often result in very significant price moves. This presents interesting profit opportunities for traders willing to take the risk. The Powershares ETNs come in two flavors. The first "long" version ( LBND ) can be purchased if you think the market for Treasuries might go up. The second "short" version ( SBND ) can be purchased if you think the market for Treasuries will fall. Traders may be bullish on Treasuries if they expect bad economic news or another market panic. In that situation, LBND is likely to profit. Conversely, if you are bullish about the global economy the Treasury bubble is likely to deflate and ( SBND ) will profit. There are other factors that could affect these notes. For example, higher inflation rates would be good for SBND while deflation (or disinflation) could be good for LBND.

These are not the first leveraged long/short Treasury ETNs or ETFs. There are also Proshares 2X Treasury ETFs under the symbols TLT (short) and UBT (Long) that are designed to accomplish similar objectives. However, the Powershares ETNs will probably suffer less from the compounding error that TLT and UBT struggle with because they replicate the monthly returns of Treasuries rather than daily returns. Although the proshares versions are currenty very popular ($4.5 Billion in assets combined) we feel that if the Powershares ETNs can attract a little volume from investors over the next few months they would be a superior choice for traders over the Proshares ETFs.

Advantages:

Overall we like these ETNs as a strategic addition to an actively managed portfolio. They are designed to replicate 3 times the monthly returns of the long term Treasury futures contracts and are very efficient when compared to the difficulty most retail traders experience trying to accomplish the same objectives in the futures market. The price is low (around $25 a share), which makes it easy to use proper money management for smaller accounts. They also represent one more alternative for aggressive investors to diversify outside the stock market. For example, if inflation did begin to accelerate (which seems to only be a question of "when?") buying SBND may be a great way to profit from the bad news as stocks lose value.

Disadvantages:

An ETN (Exchange Traded Note) is not an ETF (Exchange Traded Fund). Like ETFs, an ETN looks like a stock, trades like a stock and costs the same commissions that a stock does but its actually a bond. This means that you have some credit risk when you buy shares of these ETNs. That probably doesn't matter much to short term traders but it is a consideration for longer term traders. If the company sponsoring these ETNs (Deutsche Bank - DB) goes out of business these notes will become worthless. That is probably unlikely but who can forget Lehman?. These ETNs are LEVERAGED and leverage increases risk. For example, imagine that you bought LBND and then the Treasury market dropped 10%. That move would result in a loss of at least 30% in your holdings and it could actually be more. Most leveraged and inverse ETNs/ETFs also charge higher annual fees. These ETNS charge almost 1% per year, which is much higher than most unleveraged, indexed ETFs. Costs are your enemy and you should not just assume that you will be able to outpace fees over the long term.

Special Disadvantage:

Leveraged and Inverse ETNs/ETFs suffer from a special kind of compounding problem. You can click the link below to learn more about why it is a mathematical certainty that these investments will lose more than 3X the returns of Treasuries in a bad market, make less than 3X the returns of Treasuries in a good market and will lose money in a flat market. This is not a big problem for short term traders, where the impact is likely to be small but investors planning to hold these funds over the long term (several month or years) will be hurt by these issues. The ETNs reviewed in this article should be hurt less by this problem than the Proshares 2X versions I mentioned above because they are designed to replicate monthly returns rather than daily returns of the U.S. Treasury futures but the issue should still not be underestimated.

STRATEGYRisks of Leveraged Funds and ETNs

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


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

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