Saturday, May 16, 2009

The TBT blues

I got this article just yesterday from my good friend John Y. via email. Unfortunately no source was mentioned, so I can't link you to the original authors. With my apologies to them for not mentioning their name, I'll re-post that article here, as I find it simply stunning:

U.S. STOCKS HAVE FIZZLED this week, but are only slightly below breakeven for the year. The likes of Apple (AAPL), Google (GOOG) and Amazon (AMZN) are hanging onto gains of more than 25%. Call that a sign of hope or overconfidence, depending on your view. One top gainer is more difficult to read, but also more telling: ProShares UltraShort 20+ Year Treasury (TBT), an exchange-traded fund (ETF), is up more than 30% in 2009.

Before I explain why you should care about it, let me break down the name. ProShares is an investment fund company. “Ultra” is its way of saying this fund uses derivatives to try to double the results of an index it tracks, while “Short” means the fund is betting against that index, so managers are hoping to produce a 2% gain for each 1% the index loses. The index in this case is the Barclays Capital U.S. 20+ Year Treasury Bond index. (It used to be a Lehman Brothers index before that firm went bust.) The “20+” in the name means the index tracks Treasury bonds that mature in 20 or more years. And of course, an exchange-traded fund is an index fund that trades all day just like a stock. Put it all together and TBT is a device traders use to bet aggressively against long-term Treasurys.

Last year Treasury bonds were one of only a few investments that did well. Investors who bet on (not against) the aforementioned index using an ETF with no leverage made 34% -- almost as much as stock investors lost. Yields on Treasurys were puny and turned pitiful late in the year, but investors bought them anyway. With most other assets imploding, America’s promise to pay its debts suddenly seemed the safest bet around. It was panic buying, really: During Berkshire Hathaway’s (BRK.A5) annual meeting earlier this month, Warren Buffett showed a slide of a Dec. 19 trade in which Berkshire sold Treasury bills due April 29, 2009, with a maturity value of $5 million. The buyer paid $5,000,090.70. In other words, so fierce was demand for these Treasury bills, the buyer locked in a guaranteed loss of $90.70 just to own them.

Around that time, a SmartMoney colleague, Dan Burrows, cautioned readers not to hunker down with the herd in negative yields. Those who bought just about anything else have since prospered. Viewed in that light, this year’s run-up in TBT seems promising. It means investors have grown less panicky about stocks and other risky assets. This week the fund is giving up some recent gains, just like the stock market. Let’s hope that doesn’t suggest investors are about to pile back into Treasurys and abandon everything else.

There’s another, darker way to read the fund’s movements, though. Treasury yields, like stock dividend yields, move in the opposite direction of prices. A purchase of TBT, then, might as well be called a confident bet on higher long-term interest rates. The interest rates the U.S. government must pay on its long-term debt depend in part on buyers’ perception of its future ability to pay — or more precisely, on its ability to do so without creating too much new money. (The government will always be able to pay so long as the debt is in dollars and it controls the Mint, but those dollars might be worth less.) If Treasury buyers foresee an erosion in the value of dollars they’ve lent, they’ll demand higher interest rates.

When an auction of new long-term Treasurys last week drew weak demand, the 30-year yield rose more than 0.2 percentage points to about 3.31%. On Monday, government accountants announced this year’s budget deficit (the amount by which the debt will increase) will likely reach $1.85 trillion. That’s four times last year’s record deficit. More debt in the face of weak demand for it seems to suggest rates will rise sharply. So far, they haven’t. In fact, they’ve backed off since last week’s auction. But coming months should prove interesting times for TBT investors. If the dominant theme for Treasurys continues to be investors stampeding toward them when stocks turn frightening, TBT investors might be due for disappointment, since stock valuations are starting to look plump. If, however, Treasurys break from their see-saw ride with stocks and start reacting more to the pace of America’s borrowing, I fear for just how lucrative TBT could become as rates climb ever higher.


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