The yield on 10-year U.S. Treasury notes fell to the lowest level ever as fears over eurozone debt issues sent money into the safety of United States government bonds. A bond auction by the Spanish government, that did not go well, and a spike in the yield on their bonds saw money rotate out of European-related debt and into U.S.-issued bonds.
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Treasury Exchange-Traded Funds
The iShares Barclays 7-10 Year Treasury Bond ETF (ARCA:IEF) is only up 3% in 2012, not including dividends, but is trading at the best level ever. The small gain year-to-date is currently lagging that of the SPDR S&P 500 ETF (ARCA:SPY), however that does not take into consideration the much lower risk and volatility of IEF.
Investors who believe the European situation will continue to escalate and that the "risk off" trade is the choice for big money, should consider IEF or its peers as the end result will be lower rates and higher prices for bonds. The iShares Barclays 20+ Year Treasury Bond ETF (ARCA:TLT), which invests in longer dated bonds, is up 5.6% in 2012 and is also at an all-time high. Typically, the longer to maturity for bonds the higher the beta. So another big move down in yields should help TLT outperform IEF. That being said, if the price of bonds fall and yields rise, TLT will likely take a bigger loss than IEF.
Betting on Higher Yields
There is a group of investors who believe Treasury yields are set to bounce, and when they do it will be a significant and violent rally. I have to agree with that camp, the problem with the theory is that timing is difficult to predict. Will the 10-year fall to 1.5% before yields rally? Or will the rally begin in the coming weeks?
When investors are ready to bet on the bursting of the U.S. Treasury bubble, there are a few options to profit. The ProShares Short 20+ Year Treasury ETF (ARCA:TBF) returns the daily inverse of the underlying index of long-date U.S. bonds. The majority of the bonds in the index are slated to mature between 2039 and 2041.
Aggressive investors looking to make a leveraged bet could consider the ProShares UltraShort 20+ Year Treasury ETF (ARCA:TBT). The exchange-traded fund (ETF) tracks the same underlying index, except it returns two times the inverse of the daily performance. For example, if the index falls by 1%, the ETF in theory should rise 2% on that given day.
Because the leveraged ETFs are reset every trading day, the long-term holding of such a position is not recommended for the majority of investors. These types of products are better suited for skilled traders who know the key strategies of avoiding negative bond returns.
The Bottom Line
It is always risky to bet against a trend that requires picking a bottom. In my years of investing, I have experienced the losses associated with trying to find the absolute low point of a downtrend. The better bet is to wait for a bottom to form, and once the trend has confirmed it is over and the bubble bursts, then begin to initiate a position in the direction of the new trend. With that being said, the trend points to lower yields and higher bond prices in the near future.
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At the time of writing, Matthew McCall did not own shares in any of the companies mentioned in this article.