The Future of Yields

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George Soros and his theory

Yesterday night I was watching some interviews with top investors during Davos 2013. One with George Soros particularly interested me. He made several remarks on his famous reflexivity theory, which basically states how the interpretation of events can actually affect those events. He made a connection between his theory and the future trajectory of U.S. interest rates. Soros defended the way U.S. Federal Reserve Chairman Ben Bernanke managed monetary policy after Lehman Brothers collapsed in 2008. Nevertheless, he thinks that right now, as the U.S. economy gains momentum, it's time to start changing the current monetary policy. He is afraid that, if inflation picks up before the Fed starts acting on it by hiking rates, the market could panic, making long term yields overshoot to unhealthy levels. Thus, I started looking for investments that would benefit from higher rates. No matter what might happen with inflation, the future seems clear: Rates are headed up!

Placing a bet

The most natural investment would be to short U.S. treasuries. Ten-year U.S. Treasuries are now yielding 1.97% while 20-year Treasuries trade at around 2.70% and 30-year Treasuries yield just above 3%. These yields are extremely low in historical terms. All maturities for almost all high-graded bonds, sovereign and corporate, are at historically low rates. As soon as the Fed decides to lift rates or inflation picks up, bond prices are poised to fall fast. The easiest way to short yields are ETFs. The ETF ProShares Short 20+ Year Treasury (NYSEMKT: TBF) shorts U.S. 20-year yields and, selling for $30, is my favorite way to play a trend that sooner or later shall be here with us. In technical terms, this derivative-based ETF aims to reflect the inverse (opposite) daily performance of the Barclays Capital 20+ Year U.S. Treasury Bond Index. This ETF trades at its net asset value (NAV) and has a somewhat expensive expense ratio of 0.95%.

Another much more risky bet would be to invest in a leveraged instrument. Double the risk and double the potential reward (or loss). The ProShares UltraShort 20+ Year Treasury (NYSEMKT: TBT) is the ETF that seeks investment results that correspond to twice the inverse of the daily performance of the same Barclays Treasury index. This ETF also trades at NAV and has an expensive expense ratio of 0.92%.

The reason to short bonds with long maturities is that those should be the most affected when rates start going up. If you would rather sell bonds with shorter maturities, you can always buy the iShares Barclays Short Treasury Bond Fund (NYSEMKT: SHV). This ETF trades at NAV and has a low 0.14% expense ratio. The problem is that even if short-term bonds start yielding a higher rate, those are actually the bonds that the Fed controls more tightly. The Fed will not want yields to spike, so it's always better to short bonds that are going to be harder for the Fed to control (since you are shorting bonds, you want yields to soar!) 

Timing is key

The ETFs that I mentioned above have been losing value for years now. My favorite one, ProShares Short 20+ Year Treasury, is down by 40% since 2010, while ProShares UltraShort 20+ Year Treasury (the leveraged bet) is down by 60%. iShares Barclays Short Treasury Bond has been much more stable, reflecting how much better the Fed controls short-term rates compared to longer ones. The time to buy those ETFs is around the corner. Even if ten-year Treasuries already started to lose value (today's 2% yield is higher than last year's yield of 1.5%), the Fed is indicating that we shall not see reference rates (today at 0%) coming up this year. The reason is simple, the U.S. economy seems to be gaining momentum but unemployment, which is the key measure that the Fed is looking at, is still high. The time to short U.S. treasuries may not be here yet but I am sure it is the right time to start preparing to short. As soon as the Fed indicates that it will move its reference rate above current levels, buy ProShares Short 20+ Year Treasury!

Fool blogger Federico Zaldua does not own shares in any of the companies mentioned in this entry.

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