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The U.S. Bond Bubble

How to Clean Up When the Bond Bubble Bursts

Written by Brian Hicks
Posted December 11, 2008

As everyone who has ever invested in anything knows, it takes money to make money. For investors, that is a self-evident truth as obvious as anything ever penned by Thomas Jefferson.

However, in the world of bonds these days the market has become so twisted that investors have actually managed to turn that maxim on its head. In the bizzaro world of short-term U.S. Treasuries this week the self evident truth is now this: It takes money to lose money!

That's because in trade on Tuesday, bond buyers were so enamored of the world's safest debt, they agreed to loan Uncle Sam billions of dollars at an interest of zero or in some cases even less than that.

In fact, if you had invested $1 million in three-month bills at Tuesday's negative discount rate of 0.01 percent, for a price of 100.002556, at maturity you would receive the par value for a loss of $25.56.

And yes you read that correctly. Certain bond investors actually paid the U.S. Government for the right to loan them money. Now is that the most insane thing you have ever heard?

Of course, any scientist would immediately recognize this as something of an anomaly. An anomaly is defined as any occurrence that is strange, unusual or unique—sort of like the cool laid back girl. (Just kidding ladies).

Market watchers, on the other hand, give it something of a different description. They call it the greatest U.S. bond bubble in history. Either way, what is obvious to everyone is that it is entirely unsustainable over time.

After all, when is the last time you invested in anything you knew for a fact wouldn't make a dime?

The Latest Bubble is in U.S. Bonds

The answer, of course, is never which points a frothy old bubble in U.S. Government debt. And the truth is the bond bubble isn't really much different than the tech bubble, the housing bubble, or the commodities bubble. It is just latest bit of market insanity that is destined to pop.

This time though it is spurred on primarily by fear as the flight to safety has gone parabolic. In short, it the giant sized equivalent of stuffing cash into a mattress. On the flip side of that however, this rush to safety has only pushed bond prices higher and higher, lowering their yields.

Of course, it is important to remember that bonds prices trade inversely to their yields. So when bond prices rise yields go down, and when bond prices fall yields go up.

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Consider for instance the following example:

If you buy a bond with a 10% coupon at its $1,000 par value, the yield is 10% ($100/$1,000). But if the price of the bond goes down to $800, then the yield goes up to 12.5% ($100/$800). Conversely, if the bond goes up in price to $1,200, the yield shrinks to 8.33% ($100/$1,200).

The result is that when the herd piles into U.S. Treasuries buying them with abandon, yields and interest rates both fall.

Bernanke Fuels the Bond Bubble

Earlier this month, Fed Chairman Ben Bernanke only managed to push the herd even deeper into bonds when he basically admitted the Fed had run out of bullets. The Fed Bernanke said could buy "longer-term Treasury or agency securities on the open market in substantial quantities." "This approach," he said, "might influence the yields on these securities, thus helping to spur aggregate demand."

Needless to say, that was music to the ears of the traders in the bond pits as they rushed to in line to get ahead of a Fed that now seemed determined to force rates lower by buying Treasuries. T-notes yields have fallen to multi-decade lows as a result.

Those giant-sized bond gains were on full display when the 10-year Treasury yield touched 2.505 percent on Dec. 5, the lowest since at least 1962 when the Federal Reserve's daily records began, and since 1954 on a monthly basis. By comparison, at the bottom in 2003, yields on 10's only managed to fall as far as 3.08%.

However, as Treasuries scream higher the safe haven quality offered by them diminishes with every tick. Because when this trade eventually reverses—as it surely will— bond prices will plunge the same way housing, stocks and commodities did.

"If you draw a line it tells the whole story", said Carter Worth recently. The Oppenhemier chief market technician said, "The sheer steep day after day appreciation of Treasuries is no different than the appreciation in tech stocks in 2000 or an energy stock just six months ago. The overshoot in bonds, is just that. An over shoot."

For investors, that leaves more than a few ways to play the bursting of the bond bubble. Either you can short an exchange traded fund like the hyperbolic iShares Lehman 20+ Year Treas Bond (TLT). Or you could go long its inverse which is the UltraShort Lehman 20+ Trsy ProShares (TBT). It is an exchange-traded fund that goes up when bonds go down.

Either way, this is one self-evident anomaly that can't last forever—-especially when stocks turn up for good.

Making money, after all, is the name of the game.

Your bargain-hunting analyst,

steve sig

Steve Christ, Investment Director

The Wealth Advisory

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