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Is It Time to Short Bonds as an Inflation Hedge?

June 10, 2011 | About:
I am thinking about shorting investment grade or government bonds, or even municipal bonds which have default risk and, in some cases, terrible balance sheets. Low inflation, huge debt at sovereign and municipal levels and massive use of the dollar printing machine have made those type of bonds a very risky investment. Seth Klarman has bought inflation puts, and Prem Watsa is hedged with the relatively new consumer price index (CPA) derivatives.

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.

Cheers!

Juan

About the author:

Jose Vasquez
I was born in Spain and lived in France, Chile, USA and Belgium. I used to work in IT and Banking. I am a family man, I have a lovely wife, 3 sons and one step daughter. I have humble tastes, I like to stay home and read about companies. I started investing before the internet bubble. I knew little and liked technical analysis so my results were bad. Fortunately I did not have much to lose. Some years later in 2006, bored of doing real state investments, I opened an interactive brokers account and restarted. This time, not wanting to make mistakes, I decided to follow a model: Warren Buffett, he was at good making money via stocks. So I started reading about him, his shareholders letters, the books that he recommended, etc... I started applying his principles, reading 10K's digesting all sources of information. I started buying good and cheap companies to hold forever unless something changed fundamentally. When the housing crisis started I was 75% cash. By then I had identified good companies at very cheap prices so I invested most of my savings in stocks. It doubled fast. By the second semester of 2009 I turned my software company into an investment vehicle and dedicated myself full time to it. I changed lifestyle and moved from Belgium to the beach, Brazil, north east coast (www.kuchita.com). The goal was to keep fixed costs low in order to be able to live with a minimum 6-8% yearly return, to move away from the inhuman life of civilization and to have some peace and sunny weather. Now I can think and study about companies 60 hours/week. I can finally do what I want full time and can say that I have never been so happy, specially also with my just born 4th son, my other great kids and my sweet wife who supports me fully while I study most of the day and patiently wait for the opportunity to make a swing ! My portfolio is disclosed here: http://www.kuchita.com/view/sumo.php For more:

Visit Jose Vasquez's Website


Rating: 4.2/5 (29 votes)

Comments

deecee
Deecee - 3 years ago


Thanks Juan,

So to clarify basically the bond price would go down due to expected increase in interest rate right? Which a interest rate hike is expected after inflation, correct?

Also - how did you come about the gain of $2k? Your price was initially higher so you sell bonds? Then the price drops, yield rises, then buy bonds? The difference is the gain?

Please correct me if I'm wrong.

Thanks.

Dee
Jose Vasquez
Jose Vasquez - 3 years ago
Yes are right DeeCee, you sell the bond fund, and then if inflation expectations, real inflation, or interest rates go up the bond drops and you rebuy it gaining the difference. The risk is that there is a stock market panic for a long time that make people buy bonds as a safe heaven just because there is nothing else to do (actually you are better off investing in another country as a safe heaven if that happens but many do not consider that) or deflation or low inflation for a long time. Note that I do not believe those scenarios are likely but its better to know them.

Regarding your question on how to calculate the 2000 gain you can see the bond dynamics on the article on the part following "I'll illustrate the bond sensitivity..."
dannerhoj
Dannerhoj premium member - 3 years ago


Why not just buy TBT as a short of Treasury Bond?
Jose Vasquez
Jose Vasquez - 3 years ago
That is another option too. I personally trust more iShares ETFs than ProShares. I know that iShares are quite cheap. I also prefer ETFs that simply follow the underlying than the ones that try to replicate the performance of the inverse behavior multiplied by 2 (like the ultra short ETF family) since I think those ones use derivatives and are therefore more prone to tracking errors, but I have not verified it so a priori I keep things clear and simple.
Jose Vasquez
Jose Vasquez - 2 years ago
Update and follow up: This post from my blog shows how I have been shorting treasuries via the TLT ETF: http://investing.kuchita.com/2011/09/03/shorting-treasury-bonds-becoming-serious-other-weekly-comments/
yvonneca
Yvonneca - 2 years ago
Hi Juan,

Interesting post on TLT, I agree it looks overbought,t but for a different perspective and a bit of history on why people keep purchasing bonds with such low rates may I suggest you read Before the Accord: U.S. Monetary-Financial Policy, 1945-51

http://www.nber.org/chapters/c11485.pdf

This comes from the report document Financial Markets and Crisis

http://www.nber.org/books/glen91-1

Jose Vasquez
Jose Vasquez - 2 years ago
Thanks Yvonneca, Im reading it now, looks very interesting!
batbeer2
Batbeer2 premium member - 2 years ago
As I understand it, your strategy depends on interest rates on bonds beating inflation.

That assumption may be worth investigating some more.
Jose Vasquez
Jose Vasquez - 2 years ago
Hi Batbeer2,

It's not so simple, there are no hard rules, interest is not always above inflation but usually yes (see #6). Anyways that is just one among many factors, there are several reason why I am short on 30 year treasury bonds:

1) Quantitative easing. QE is like a drug with a bad long- term side effect. You can feel good over the short- term, only to suffer from a host of maladies that hit you later—not the least of which is a fear that the value of fiat currencies will erode.

2) Money supply (MZM) velocity increases. That is, the $3 trillion increase in the money supply referenced above gets put to work. 15 Trillion plus US debt and running with no signs of stopping.

3) China demand continues. You have read and seen pictures of vacant Chinese cities, and job creation has Cartoon by Paresh Nath. Used under license. not been keeping pace with the influx of rural citizens into urban areas. But at the end of the day, China is the world’s largest creditor nation, with $3.2 trillion in foreign exchange reserves. If necessary, that cash could be pressed into service to buy China both jobs and time. The government could build a whole city, tear it down, and then do it again if it so desired. That wouldn’t be the highest and best use of capital, but it would give the economy time to grow into the infrastructure that’s been built. I don’t suggest that China cannot stumble. It can—even severely. I just find myself incapable of making such a wager one way or another.

4) Value-added tax. There has been talk of its introduction, which would be inflationary, at the margin.

5) Protectionism. U.S. reacts to the artificially low currencies of some of our large trading partners by putting in place inflation-inducing protectionist policies.

6) Economic growth. Longer term, the global economy will grow, and demand for homes, autos and other goods and services will increase, absorbing excess capacity.

7) Artificial low bond rates due to safe haven buying and idiot policies like the operation twist.

After all the back and forth, I still fall into the camp that believes there will eventually be inflation, largely because of the unprecedented liquidity creation noted in our arguments for inflation. However, that doesn’t mean that deflationary pressure won’t rule the roost for the foreseeable future.

Cheers!

Juan

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