Optimists and Pessimists Might Bet Against Treasuries

Watch stocks you care about

The single, easiest way to keep track of all the stocks that matter...

Your own personalized stock watchlist!

It's a 100% FREE Motley Fool service...

Click Here Now

Last week, President Obama signed the $787 billion stimulus bill, and investors celebrated by buying ... Treasuries? Indeed, once again government obligations were the piece de resistance for those who apparently didn't find much hope in the thousand-page legislation spawned by Congress.

As equity markets are retesting last November's lows, we are again at an inflection point. Ongoing concerns about bank solvency (particularly with Citigroup (NYSE: C  ) and Bank of America (NYSE: BAC  ) ), rising unemployment, and faster-rising budget deficits overshadowed optimism about the administration's spending program.

Betting on -- or against -- Uncle Sam
In the midst of these developments, one of the many imponderables facing investors today is the outlook for government bonds, which many analysts consider overvalued. The Financial Times reported recently that sovereign wealth funds in the Middle East are increasingly anxious about their exposure to U.S. government obligations. They are apparently concerned about their sizable exposure to the dollar (partly because oil is priced in greenbacks) and nervous about mounting U.S. government spending. They are not alone.

Following the collapse of one-time blue-chip companies like AIG (NYSE: AIG  ) and Fannie Mae (NYSE: FNM  ) , the panic in financial markets last fall was such that investors dove en masse into Treasuries, briefly driving yields into unsustainable negative territory. Since then the yield curve has become steeper and prices have receded to more reasonable levels. But, there may be more to come.

As policy-makers have flooded the market with liquidity, staving off the possible collapse of the banking system, the government's balance sheet has exploded. While this has been a good thing for the financial markets, it could seed an upturn in inflation or a downdraft in the dollar, either of which could cause Treasury prices to drop further.

Staggering numbers
Consider the most recent report to the Secretary of the Treasury from the Treasury Borrowing Advisory Committee, presented earlier this month. The committee estimates that "The net supply of Treasuries in 2009 and 2010 combined seems likely to total more than $3 trillion and could climb as high as $4 trillion."

"The sheer magnitude of the paper set to be issued raises the possibility that investors at some point will demand a concession of some sort, lifting yields in parts of the terms structure beyond those justified by macro fundamentals."

The committee further warns that "international developments do pose some risk to the Treasury market, especially as the increase in supply accelerates further." It points out that foreign investors today hold almost 55% of marketable Treasury securities, up from about one-third in 2000.

Already the numbers show a worsening budget gap. The federal government's income statement for January shows a deficit of nearly $84 billion, versus an $18 billion deficit a year earlier; fiscal year to date (beginning Oct. 1), the deficit is $569 billion, compared with $89 billion in the previous year. And we're just getting started on the spending ramp-up.

Under a number of different scenarios, including an economic recovery or a worsening picture that might require even greater government outlays, investors might choose to sell short Treasuries.

So, how do you do that?
The easiest way is to buy an exchange-traded fund (ETF) that does it for you. The first ETFs that gave investors the opportunity to bet against Treasury bonds were created in May 2008 by ProShares, shortly after PIMCO bond investor Bill Gross called Treasuries "the most overvalued assets in the world, bar none."

ProShares simultaneously launched two "UltraShort" funds, UltraShort 7-10 Year Treasury (NYSE: PST  ) , which inversely tracks the 7-to-10 year Lehman (now Barclays) Treasury bond index, and UltraShort 20+ Year Treasury (NYSE: TBT  ) , which inversely tracks the Barclay 20-plus year bond index. Both use two times leverage to enhance results.

Michael Sapir, CEO of ProShares Advisors, says that both funds were among the most successful new ETFs in attracting assets last year. In investment terms, both were immediate failures. The UltraShort 20+ Year was down 46% -- a disaster, even by last year's standards -- while UltraShort 7-10 Year fared better, losing 25%. Each has regained some ground in 2009.

Despite the inauspicious start, the two funds have attracted more than $3 billion combined. The funds, according to Sapir, are invested mainly in swap agreements, constructed so that the funds mimic shorting the actual Treasury bonds. Because of the leverage, if the underlying bonds fall 5%, the ETF is meant to rise 10%. The good news is that investors stand only to lose their investment in these vehicles; selling a stock short can place an investor at unlimited risk if the stock goes up.

Risks you should know about
The bad news is that investors are exposed to counterparty risk. That is, if ProShares enters into a swap agreement with an institution that fails, investors could be hurt. Sapir says that his firm has minimized that risk by only dealing with highly rated banks and investment institutions, and by limiting its exposure to any one bank. He adds that investors are at risk only for the incremental gain or the loss in a swap, rather than for the entire amount of the swap.

There's another notable risk: The two funds aim to replicate the bond index each day. To quote the prospectus: "Short ProShares are designed to correspond to the inverse of the daily performance or twice (200%) the inverse of the daily performance of an underlying index. The Funds do not seek to achieve their stated investment objective over a period of time greater than one day." Over time, significant discrepancies will evolve because of the nature of compounding. In periods when the markets are especially volatile, like last year, those discrepancies might mean that investors' returns over a period of a year, say, will fail to closely track Treasuries.

ProShares does not provide data on how well these funds achieved their objective of doubling the performance of the underlying bonds since the funds opened, since they have been up and running for less than a year.

However, we can look at the performance of the group's UltraShort S&P 500 (NYSE: SDS  ) fund, which is also leveraged 2:1, for guidance. In 2007, the S&P 500 rose more than 5%, assuming reinvestment of dividends; during the same period, the ETF was down just under 4% -- good news for investors, but not the two-times outcome that might have been expected. The performance and construction of the funds is complicated, which may be why there are no competing products to short Treasuries at present.

Despite the risks, the ProShares funds may be able to provide directional correlation for individual investors who are positive about a turn in the economy or who can see pressure building on the yields that the government may have to offer on its obligations. Remember, though, that they reset daily; while they may prove to be attractive opportunities, for long-term investors, a handy means of shorting Treasuries remains elusive.

For more Foolishness:

Fool contributor Liz Peek owns shares of Citigroup, Bank of America, and the UltraShort 20+ Year Treasury ETF, but of no other securities mentioned. The Fool is investors writing for investors.

Read/Post Comments (0) | Recommend This Article (6)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

Compare Brokers

Fool Disclosure

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 837077, ~/Articles/ArticleHandler.aspx, 10/22/2016 2:36:23 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...

Today's Market

updated 17 hours ago Sponsored by:
DOW 18,145.71 -16.64 -0.09%
S&P 500 2,141.16 -0.18 -0.01%
NASD 5,257.40 15.57 0.30%

Create My Watchlist

Go to My Watchlist

You don't seem to be following any stocks yet!

Better investing starts with a watchlist. Now you can create a personalized watchlist and get immediate access to the personalized information you need to make successful investing decisions.

Data delayed up to 5 minutes

Related Tickers

10/21/2016 4:00 PM
AIG $60.00 Down -0.07 -0.12%
American Internati… CAPS Rating: ****
BAC $16.67 Up +0.11 +0.66%
Bank of America CAPS Rating: ****
C $49.57 Down -0.01 -0.02%
Citigroup CAPS Rating: ***
FNMA $1.74 Down +0.00 +0.00%
Fannie Mae CAPS Rating: ***
PST $20.44 Down -0.03 -0.16%
ProShares UltraSho… CAPS Rating: *