Shorting Treasurys with ETFs

August 04, 2011

The U.S. looks for now to have averted a catastrophic debt default, but can it stop a downgrade?

 

Two weeks ago, Standard & Poor’s said there was 50-50 chance that it would downgrade U.S. debt, even if a deal like Tuesday’s raising the borrowing limit were reached. Bill Gross, who runs PIMCO’s flagship Total Return Fund, is skeptical about the compromise, while Mohamed El-Erian, the firm’s chief executive and chief investment officer, thinks U.S. Treasurys may still lose their “AAA” credit rating.

But even with threats of a potential debt downgrade looming, Treasurys have been rallying in recent weeks. As Devin mentioned in his blog, weak economic data and the increased threat of a double-dip recession may again be turning investors towards “safe-haven” investments like Treasurys.

While the true repercussions of a potential U.S. debt downgrade are impossible to predict, some are so bearish on Treasurys that they’re willing to short them. In a recent interview with IndexUniverse, famed investor and creator of the Rogers International Commodities Index, Jim Rogers, said that he’s short U.S. government debt, arguing that Treasurys “are going to be one of the great shorts of our time.”

Rogers isn’t alone. The “short-Treasury” trade seems to be gaining momentum. The ProShares UltraShort 20+ Year Treasury Fund (NYSE Arca: TBT) is now the world’s largest inverse fund and third largest Treasury ETF in the country, with over $5.5 billion in assets under management.

Luckily for investors looking to short Treasurys via ETFs, there are several options.

One obvious way to do so is by shorting the various Treasury ETFs on the market, such as the iShares Barclays 20+ Year Treasury Bond Fund (NYSE Arca: TLT) and the iShares Barclays 7-10 Year Treasury Bond Fund (NYSE Arca: IEF). But shorting interest-paying bond ETFs comes with a few caveats.

Most importantly, when you short a “dividend” paying ETF such as TLT -- which is currently yielding over 4 percent -- you’re actually responsible for paying those “dividends” as the borrower of shares. So, over the long run, this responsibility can eat away at your returns. Shorting also requires having a margin account, so, for example, this option doesn’t work in individual retirement accounts (IRAs).

Another way to short Treasurys is by going long inverse bond funds, such as TBT or the ProShares UltraShort 7-10 Year Treasury Fund (NYSE Arca: PST). However, over the long haul, leveraged funds with a daily rebalance can eat away at your returns due to compounding, especially in bumpy markets.

A less-volatile way to short Treasuries might be through non-leveraged inverse funds such as the ProShares Short 20+ Year Treasury Fund (NYSE Arca: TBF). TBF aims to track the daily inverse of the Barclays 20+ Treasury Index, the same underlying index as TLT.

But over time, returns in even non-leveraged inverse funds can still deviate significantly from their indexes, again due to daily compounding, which ProShares explains on its website. These huge disparities can clearly be seen in this chart, which compares one-year returns for TLT, TBF, and TBT. Again, all three ETFs are based on the same underlying index.

IU_ShortingTreasurysBlogChart_08042011

 

Source: Bloomberg

TLT returned roughly 1.5 percent over a one-year period, but TBT was down almost 20 percent in the same period. So, with 14 inverse Treasury funds now trading, it’s crucial for investors to really understand how these products work.

Some fund issuers are attempting to mitigate the long-term effects of daily compounding by resetting the leverage monthly, instead of daily. The recently launched triple-leveraged PowerShares DB 3X Short 25+ Year Treasury Bond ETN (NYSE Arca: SBND) is one such example.

But SBND also happens to be based on a futures index, which introduces another variable that investors need to understand clearly before jumping into such securities.

Investors do have various factors to consider when shorting Treasurys through ETFs. But currently, no inverse funds currently provide perfect one-for-one inverse exposure for the long-haul because leveraged and inverse funds really aren’t designed for long-term investing.

That said, for those intent on holding inverse funds for an extended period to short Treasurys, all the volatility and uncertainty these days means that non-leveraged inverse funds like TBF might be a safer play than leveraged inverse funds such as TBT.

 

Find your next ETF

Reset All