Is Short Selling U.S. Treasury Bonds

Transcription

1 1 2 Is Short Selling U.S. Treasury Bonds a Good Idea? How do you Short Sell a Bond? Is Short Selling U.S. Treasury Bonds a Good Idea? Special Issue By Kalen Smith and edited by Paul Khoo Bonds are often considered to be fairly safe investments, but their trading prices can endure as much fluctuation and volatility as stocks. As a result, it has become increasingly popular to take advantage of the opportunity to short sell bonds. But what exactly causes the value of bonds to decrease and how can one go about short selling a specific bond or class of bonds? Let s explore these areas in greater depth below: Why would you short sell a Bond? You short sell a bond for Here are some reasons the same reason you short why you may want to sell a stock because you short sell a bond: think it will decline in value. Many bonds provide a fixed income, which is one reason why they re an attractive investment. But the value of that income, and hence the bond itself, is affected by interest rates, current inflation, the company guaranteeing the bond, and demands for bonds in general. 1 Interest rates are likely to increase Historically, interest rates are low. Many investors are getting frustrated that interest rates on Treasuries are now at about a quarter of a percent. Fewer investors are willing to tolerate such dismal returns and either aren t buying or are selling their holdings. When interest rates increase, the value of existing bonds decline. This is because investors will be able to get a better interest rate purchasing a new bond. Interest rates may rise if the Fed is convinced that US recovery is sustainable. The Fed s have been under a lot of pressure to drive inflation to avoid stagflation and deflation. This may drive interest rates up further over the long-run. In other words, treasury bond price values will decline if interest rates stay where they are or if they increase. Either way, this creates a good opportunity for investors to establish a short position on long dated US Treasury Bond. 01

2 PRICE IMPACT OF A 1% RISE / FALL IN INTEREST RATES ON U.S. TREASURIES Note: By shorting U.S. Treasury 30 years, a 1% rise in yield would generate a return of +18.6% Source: US Treasury, Barclay Capital, JP Morgan, FactSet, 31 March 2015 FOMC PROJECTS GRADUAL HIKE Source: Federal Reserve, FactSet, J.P. Morgan Asset Management. Market expectations are the federal funds rates priced into the fed futures market as of the date of the March 2015 FOMC meeting. *Forecasts of 17 Federal Open Market Committee (FOMC) participants, midpoints of central tendency except for federal funds rate which is a median estimate. Data are as of March 31, Inflation increases The real rate of return on a bond is the difference between the interest it pays and inflation. If inflation increases, bonds will become less attractive since their interest rates do not account for inflation. 02

3 For Anyone Concerned at Bond Rout, Don t Say You Weren t Warned by Wes Goodman After analysts got it wrong last year, bonds are doing what forecasters expected in plunging. Byron Wien at Blackstone Group LP says there are more losses to come. At the end of 2014, Wall Street s forecasters predicted 2015 would be a disastrous year for benchmark Treasuries. With Federal Reserve Chair Janet Yellen poised to raise interest rates for the first time in almost a decade, prognosticators were convinced yields had to rise. The latest Bloomberg surveys of economists suggests the selling isn t over. Analysts don t have a great track record. Almost everyone who foresaw a selloff in 2014 as the Fed ended its bond-buying program was caught by surprise as a tumbling inflation rate pushed Treasuries higher. They re proving to be correct this time around, with Treasuries plunging 2.2 percent since the start of April, based on data compiled by Bloomberg. German 10-year yields have surged to 0.72 percent from 0.05 percent last month. Yields are going to go higher, said John Gorman, head of dollar interest-rate trading for Asia and the Pacific at Nomura Holdings Inc. in Tokyo. People are coming to terms with the fact that the Fed is going to raise sometime toward the end of this year. The economy is in an upward trend. Nomura is one of the 22 primary dealers that trade directly with the Fed. Benchmark U.S. 10-year yields were little changed at 2.29 percent as of 6:49 a.m. in London, according to Bloomberg Bond Trader prices. They have risen from this year s low of 1.64 percent in January. The price of the percent note due in May 2025 was 98 18/32. 3 Demand for bonds is declining Most bonds are sold to large institutions and foreign governments. When these organizations have less interest in purchasing bonds due to declining yields or higher perceived risk, the value of those bonds can decrease dramatically. With Fed has stopped the bond buying program, as part of their tapering plan, is an example of reduced demand for US Treasury Bonds. Institutional and foreign support of U.S. Treasuries is declining soon. China is the largest single holder of U.S. Treasuries, holding approximately 8% of all U.S. debt, and has been selling its holdings. Bill Gross, the manager of the largest bond fund in the country, and Warren Buffet, another legendary investor, are both bearish on long-dated U.S. Treasuries and bonds. 4 Higher rates in the U.S. will be one of the driving forces behind a strong U.S. Dollar Federal Reserve continues to accommodative monetary stance to ensure the U.S. economy growth is sustainable, and hence running the risk of inflation may skyrocket over in the long-run. The president of the Fed Bank of St Louis said in March 2015 the central bank risks being behind the curve on inflation if it doesn t raise its benchmark interest rate from near zero soon (Bloomberg, 28 Apr 2015) For example, Bill Gross, a famous bond trader, is currently short-selling U.S. Treasuries because he and other analysts believe the U.S. government will be driving interest higher over time. While short selling bonds is an appropriate strategy for many investors, it s important to keep in mind the potential risk for longer than expected rates hike by the Fed. Forecasts Trimmed At the start of 2015, the Bloomberg surveys projected the yield would surge to 3 percent by year-end. Though economists have reduced the figure, they still see it climbing to 2.41 percent, based on the responses, with the most recent given the heaviest weightings. The Fed will probably raise borrowing costs in September as the economy improves, said Wien, the vice chairman at New York-based Blackstone, which specializes in alternative investments such as private equity and real estate. Interest rates are going up, and I ve thought that for a long time, he said this week in an interview with Bloomberg. I don t think they re going up a lot. A surge in yields like the one under way now is cause for bondholders to give thanks that their investments make interest payments. If U.S. 10-year yields rise to 2.41 percent by Dec. 31 as projected, an investor who bought today would break even as the coupon payments offset the drop in price, data compiled by Bloomberg show. 03

4 FAMOUS Investors JOINING THE CALL Growing discontent with how low yields have gotten, and the sense that it can t last too much longer with an economy that s showing signs of life. WARREN BUFFET If I had an easy way, in a non-risk way of shorting a whole lot of 30-year bonds, I d do it. But I think that bonds are very overvalued, I ll put it that way. Self-made billionaire, investor, philanthropist, CEO of Berkshire Hathaway with total assets over USD 520 billion Source: News Article from Buffet and Gross Agree: Slump in 30-Year Bonds Makes Good Sense, 4 May 2015 BILL ACKMAN I don t like fixed income as a category, particularly at today s interest rates. Founder and Chief Executive Officer of Pershing Square Capital Management LP with total assets of USD 18 billion Source: News Article from Buffet and Ackman Hate U.S. Bonds and the Losses are Piling Up, 6 May 2015 BILL GROSS The bull market supercycle for bonds is ending and credit-based oxygen is running out. I acknowledged that my call for the end of the bond rally in both February and April of 2013 were too early. Financial Manager and Author, Cofounder and Co-Chief Investment Officer of Pacific Investment Management LLC Company (PIMCO) with total assets of USD 1.59 trillion Source: News Article from Bill Gross: The Bull Market Super Cycle is Nearing its End, 4 May 2015 PAUL SINGER Today, six and a half years after the collapse of Lehman, there is a Bigger Short cooking long term claims on paper money i.e. Bonds. Founder and CEO of Elliott Management Corp with total assets of US$23 billion Source: News Article from Paul Singer: This is the new big short, 28 May

5 The concept of short-selling Treasuries is an idea that many investors have started seriously considering in recent months. How do you short sell a bond? Generally, you can t short sell a bond directly through your broker the same way you would a stock. However, there are other ways to conduct such a trade: 1. Short a bond exchange-traded fund (ETF) Purchasing a put option is one way to seller. By doing so, you lock in current mitigate potential losses; if the value bond prices, and then buy the actual of the bond fund increases, your losses bonds at the future, lower prices when are limited to the purchase price of you must provide the buyer with the An ETF is a fund that specializes in the put. bonds at the agreed-upon date. This groups of assets, the value of which strategy can result in large losses if the moves in tandem with the underlying 3. Treasury put options securities. Many ETFs specialize in You can also purchase put options on specific bond classes, such as 7-10 specific Treasuries, which affords you 5. Put bonds year Treasuries. Brokers will usually let the opportunity to sell at a specified Some individual bonds can be acquired you place short orders on ETFs just like price before the expiration date. For with a put option and are known as any other security. This is the simplest example, put bonds. With this option, the way for investors to leverage on a options on the 5-Year Treasury Yield. you can purchase put rising yield environment. bonds increase in price, however. holder can exercise and force the issuer to repurchase the bond at some 4. Bond futures point over the lifetime of the bond. Futures are another alternative. As the Usually, this valuable put feature will Put options exist for some bond ETFs seller ( short position ) in a bond require the investor to sacrifice a just like they do for stocks and other futures contract, you agree with the portion of the bond yield. This option securities. A put option affords you the buyer ( long position ) to issue the offers investors the stability of bond opportunity to sell the ETF at a pre- bonds at a future, specified date for a investments while also providing an determined price should the ETF price agreed upon now. Thus, if you exit strategy should the bond s price decline in value. These options will expect the price of bonds to fall, you decrease significantly in value. have a specified time period within can make immense profits by entering which into bond futures contracts as the 2. ETF put options you must exercise them. Source: This article was originally extracted from and OUR RECOMMENDATION OFFSHORE Proshares Short 20+ Year US Treasury ETF (TBF) Proshares Ultrashort 20+ Year US Treasury ETF (TBT) DISCLAIMER - The information contained in this document is of a general nature only and does not take into account your particular objectives, financial situation or needs. Accordingly the information should not be used, relied upon or treated as a substitute for specific financial advice. Whilst all care has been taken in the preparation of this material, no warranty is given in respect of the information provided and accordingly neither Standard Financial Adviser nor its employees or agents shall be liable on any ground whatsoever with respect to decisions or actions taken as a result of you acting upon such information. Standard Financial Adviser Sdn Bhd ( K) Licensed Financial Adviser & Islamic Financial Adviser Corporate Unit Trust Advisers CMSL/A0173/2007 Corporate Private Retirement Scheme Adviser Head Office B-8-3A, Block B West, Menara PJ8, No.23, Jalan Barat Petaling Jaya, Selangor, MALAYSIA Tel: Fax: Enquiry: enquiry@standardfa.com Northern Region Office B, Menara BHL, Jalan Sultan Ahmad Shah, Georgetown, Penang, MALAYSIA Tel: Fax: Website: 05