Just as before the crisis the credit default swaps were in fashion, now you have new inflation related derivatives coming on the scene. As before you had huge debt in financial institutions off balance sheets, now you have the debt in the government with off-balance-sheet entitlements such as Medicare, and debt owed by Fannie and Freddie — history rhymes. Many bonds are yielding close or less than inflation on nominal terms, five-year interest rates have moved lower to a yield of close to 1.5%, with core inflation running somewhere between 1.5 percent and 2 percent, as soon as a bit of inflation comes they will drop. The risk is that the crisis continues and people continue buying them as a safe haven even if they get nothing out of them. Another risk is that we have deflation like Japan, but I think that's very unlikely with all of the debt and money printing going on.
So as a hedge I am planing on shorting some bonds. The good thing is that it is basically impossible that they go up much more and make me lose more than I could stand. The iShares ETF AGG is at 107.5 now and yielding 3.3% only, as low almost as ever. That is why even Google (GOOG) is issuing debt for the first time even though their net cash position is way more than 30 billions. Seldom has money been so cheap. The 20 year Treasury Bond Fund (iShares TLT ETF) is also yielding basically nothing, less than inflation on nominal terms, and are very sensitive to inflation due to their long term.
Here is a how the hedge can be carried out in practice by a retail investor:
Some bond yields are already at historic lows yielding on real terms less than inflation. So if you believe there will be inflation the yields will go higher due to a pick up on interest rates to control inflation and the value of the bond will fall. Actually just with rising inflation expectations they fall, since money exposed to inflation is worth less, especially when it is money due in the long term. So even if the yields go just a bit higher, the face value of the bond will drop, making you earn money on your hedge. The TLT (20 year treasury) ETF can be used for this by the retail investor.
I'll illustrate the bond sensitivity to inflation with an oversimplified example:
The TLT ETF @97.26 is yielding 4.2% which corresponds to a annual coupon of 4.08 dollars that you receive, if you are long, in the form of dividends every month. Conversely, if you are short, you pay for that coupon/dividend to the person who lent you the ETF.
If the inflation expectations go up a bit, lets say if the yield goes up less than 1% to 5.1%, then those same bonds would have to be priced at around 80 so that the 4.08 coupon matches a 5.1% yield (4.08/80=0.051). So if you shorted at 97 you gain 97-80-(dividends you had to pay for shorting to the one who lends you the ETF to short it, which are 0.35 cents per unit per month). So as you see the bond would drop quite strong if the long term inflation expectations go up. This is because a long term bond is extremely sensitive to inflation because on the long term money becomes worthless with higher inflation so a higher yield is required to compensate for that. Higher expactations can be devastating for long term bond holders, it does not necessarely drop only when the interests rates go up. Of course if they do go up then even better for the short position because then the bond will go down almost certainly.
Only with the TLT ETF you have three hedging options to profit from this sensibility that I can think of:
1) Short TLT when it is quite high, such as now at $97. The higher the better of course, but do not rely on it going very high because given the already low yields, that might simply never happen. Another possibility is to short several times as it goes up to avoid being left out. Note that if you short 100 ETF TLT units you will have to pay every month around 30 (0.3%) dollars to pay the dividend yield but if TLT drops that would mean very little considering that if inflation goes up just a bit the bond will fall quite a lot making those payments relatively small. If TLT falls to 80 or less you make around 20% on the short or $2000 per each 100 ETFs shorted. It would just take a bit more than 1% pick up in inflation to do that. The "good" thing is that the 20 year Treasury bonds are extremely sensitive to inflation.
2) Buy TLT puts, the longer term the better, to avoid time value decay. You can buy the strike 85 puts for January 2013. There you do not have to pay anything monthly related to the dividend and can lose if the inflation never goes up meaningfully in that period.
3) Short the non-dividend protected December 2011 future. Here you have to pay nothing monthly; therefore the price is lower, so you start shorting from a lower value to compensate for the missing dividend/coupon payments. The advantage is that you use much less money to short a future than an ETF or a stock.
All alternatives are basically the same. The puts allow you to use much less money, and you limit your possible loss to the value of the puts, but you earn a much higher percentage on them if inflation picks up meaningfully. Note that TLT has been criticized for tracking errors, but those errors are because they under perform the treasury bonds, so actually that is a problem if you are long, for shorts, that tracking error actually plays on your favor. Also note that the derivatives (puts and futures) represent 100 TLT of the underlying ETF so shorting one future at 97 is like shorting a 9700 dollar amount. The advantage of the ETF is that you can short as little as 1 ETF and average your short sale, if you have a low commission broker then it becomes interesting to short several times small amounts.
Seth Klarman is doing this. He mentioned it on an interview which can be downloaded here. You can view it as (cheap) insurance. On the other hand, directly shorting the ETF can make you earn immediately with any pick up in inflation, but you will use more of your money. The futures are a middle ground between the options and shorting the ETF: You use little money, though not as little as the puts, you earn immediately on any inflation pick up, and there is no option time value decay involved.
The risks: Deflation or persistent long-term very low inflation. In such scenarios the yields could go even lower, making the bonds go higher. They could reach $120 like in the aftermath of the 2008/2009 crash. In that case if you panic and sell you would lose $2000 or 20%. Also the same could happen if there is a panic, for whatever reason, on the stock market and everyone starts buying bonds. So in worse case I see the loss is limited, but since I believe inflation will pick up because of the large amount of debt and printed money, I think the probability to earn money far outweighs the probability to lose. Remember that shorting in this case has not an unlimited risk like when you short a stock and it goes up forever, because inflation has never been -5% or -10%.
I see it as a hedge for my stocks. So if the interest rates/inflation picks up that should generate negative pressure to stocks, and you could make up for that loss with what you earn with the falling bonds due to the higher yields. But on the other hand if inflation or interests never go up, then you might lose on the hedge, but a limited amount because the yields are already very low.
Disclosure: I have been making tests by using all methods on my paper account, which is an exact replica of my real account on Interactive Brokers, I bought puts, sold the ETF and sold the futures to follow them easier. I would ideally prefer a higher entry point so I am following them very closely and hope for the irrationality to keep on going long enough to let me in with a big enough amount. As a starting point I already set my first limit orders to sell a small quantity of the TLT ETF @97.4 and of the AGG ETF @107.7, both were close to be filled today.
PD: Seth Klarman bought deep out of the money puts on bonds as a cheap insurance against disaster inflation. Here is what he mentioned on the interview I referred to:
We have bought way-out-of-the-money puts on bonds as a hedge against much higher interest rates. If rates reach 5–7 per-cent, we won’t make anything on the hedge. But if rates go to double digits, we can make anywhere from 10 to 20 times over money, and if rates go to 20 or 30 percent, we can make 50 or 100 times our outlay. The puts are one kind of disaster insurance. It’s cheap insurance in the same sense that if you have a $400,000 home and homeowner’s insurance costs $2,500 a year, you’ll buy the insurance.