“Bonds finally ready to crack” Safe Money Report

by Travis Johnson, Stock Gumshoe | April 25, 2008 10:27 am

A reader recently sent me a note about a teaser recommendation from Martin Weiss[1] and the Money and Markets folks regarding bets against long term bonds.

This wasn’t really a complicated teaser, so this will just be a short note …

Here’s the quote from the sales letter, which was trying to get you to take a trial of Safe Money Report[2]:

“First, I’ve been telling you to avoid long-term bonds for a long time. So if you’ve been following my writings, you shouldn’t be holding any. But if you are still holding long-term paper, I’d dump it — fast.”

“Second, if you want to go a step further, you can even profit from falling bond prices using certain, specialized funds that “short” bonds. Martin and I recently recommended one to our Safe Money Report subscribers.”

This is an interesting call — there are no ETFs that offer inverse exposure to long term bonds at the moment … though you can always sells short one of the long bond ETFs, like the popular high-volume Lehman 20 year treasury index (TLT), or buy puts on the same.

The point is essentially that inflation is going to destroy long term bonds, especially from these already inflated bond prices for treasuries. Treasury bonds have gotten very expensive recently (meaning, very low yield) because of the “flight to safety” of folks who want that Uncle Sam guaranteed principal, but the yields on treasury bonds have been negative in real terms for some time (meaning, the effective yield for folks buying bonds today is lower than the current rate of inflation).

So … if you think that’s going to end sometime, and that investors will at some point decide to stop losing money in bonds, then you have to think that the prices of bonds will have to fall so that yields can go up and either get closer to, or above, the rate of inflation.

I don’t know if this will happen, or when — a couple years ago when yields were at 5% the conventional wisdom was that they had to go up because they were artificially low, but some folks who stuck with bonds made a lot of money over that time.

Sometimes there’s more to the story than just current inflation — a lot of this depends on psychology and fear of stocks (if you fear stocks, there’s little else that massive investors can do than buy bonds), fear of the economic environment or possible catastrophes, currency market moves (massive pools of treasury bonds are held by foreign central banks and governments in part as a way to keep the dollar from collapsing further, if they choose either to buy more or to liquidate that will impact the market dramatically either direction), and faith that the federal reserve will bring us back to low inflation. And of course, policy decisions make a difference, too, if the government cuts back significantly in its borrowing (seems awfully unlikely anytime in the next 30 years, thanks to social security and medicare obligations, but anything is possible and it has happened before to a limited degree), then the demand for treasury bonds might possibly exceed the supply.

So those are some of the things to consider if you’d like to climb in and make a bet on rising interest rates … but how would you do so as an individual investor?

If you don’t want to buy puts against or short one of the treasury bond ETFs, there are two fairly well-known regular mutual funds[3] that bet on rising interest rates by shorting bonds — one of these is very likely to be the one that Weiss’s folks are recommending:

Rydex Inverse Government Long Bond Strategy (RYJUX, used to be called Rydex Juno)
and
ProFunds Rising Rates Opportunity (RRPIX)

Keep in mind that these funds have been abysmal for investors in many years, often ranked among the worst “wealth destroyers” among mutual funds. Investing in either of these funds is a significant market timing bet unless you’re just using it to hedge a position in treasury bonds (it’s an expensive hedge — both funds charge dramatically higher expense ratios than do most long bond funds, near 1.5%).

And just as a caution, the first line of the Morningstar[4] analyst writeups on both are as follows:

“Recent lessons should discourage investors from using this mutual fund to time changes in interest rates.” (RYJUX)
and
“Investors should be wary of this mutual fund.” (RRPIX)

Morningstar might be too cautious, and if you believe that you really are good at predicting when and where interest rates will go then perhaps you could do very well with these funds.

I tend to agree with the recent comments on CNBC by Mohamed El Arian of PIMCO, who said, “investors in general don’t have enough protection from inflation, while we’re entering a world of higher inflation.” Betting against bonds is one way to protect yourself from high inflation, but there are other ways too, and they’re often cheaper — inflation protected bonds, gold[5] and other commodities, etc. Commodities have climbed so far, so fast that it’s hard to say they’re a simple inflation hedge anymore, but I certainly can’t predict the movement of that market.

Personally, I do own some individual Treasury Inflation[6] Protected Bonds[7] (20 year ones, in my case). And I have a small exposure to physical gold and silver[8] and a few miners — all of those investments together make up something between 5-10% of my portfolio, which I’m comfortable with as an inflation hedge. I may pick up some more TIPS in the coming months, they’re currently priced at about a 2% yield off of a principal that adjusts for inflation, so they can’t go all that much lower, and they can’t go below par at maturity if deflation[9] instead becomes a problem (though if we have inflation for a few years, then deflation, the inflation boost would probably be worked down to nothing). It’s also worth noting that many stocks do fine in inflationary times, and that stocks on average, with their higher long term returns, may well be the best long term protection against an eroding portfolio.

I’m not interested in the inverse bond funds, though they may work very well for some period of time … if you’d like to share your inflation protection play or idea with us, please feel free … and don’t let worries over $5 gas ruin your weekend.

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