Higher Bond Risk Starting to Come Home to Roost

Bonds

Over the din of all the moaning and groaning about low treasury yields, we told our readers to be wary of the higher risk represented by this. This is now starting to kick in.

The price of a security, whether that be stocks, bonds, or anything else, is dependent upon future expectations. With a stock, we expect it to rise over time, place bets that this may happen, and the bets themselves will influence the stock’s movement forward as expectations increase.

There really isn’t very much that will limit how far a stock can go, although the more quickly that it moves up, the more likely people will be taking their profits. We can see this with anything from a brief spike which creates momentary excess that gets quickly taken down, to the so-called bubble in 2000 where investors exited their positions en masse and crashed the market essentially.

While we do need to be careful with the price of stocks rising, and be ready to step aside when things start to turn and the selling pressure picks up too much, bonds are a different animal and there are structural limitations that need to be accounted for as well.

If we’re looking to understand the price movement of bonds, we need to actually look at bond prices and not just yields, and yields aren’t even meaningful for this unless you are actually planning on holding them to maturity. Even in this case, it’s not the current yield that matters, it’s the yield you got when you bought the bonds, and the impact of this is an entirely personal one. The moment you buy, the price changes, and so does the yield, which only matters to those looking to buy now, not you who have already bought.

We buy bonds at certain prices, and as these prices change, this very much influences our positions, as this determines the value of our bond holdings. If you buy bonds and the price goes down, they are worth less, and your yield doesn’t matter to anyone but you because there is a new one based upon the current price that present buyers become subject to.

We therefore need to pay close attention to the price trends of bonds, and while we can get an idea of this by looking at how yields have moved, looking at price movements instead provide us a more transparent view of how things have changed and how this affects the value of our positions.

Bond funds do make this all quite transparent though, and you can view how things have played out on charts by looking at the chart of a bond fund. We’ll use the iShares 20+ Treasury ETF as an example, one that we have used in prior articles as well as this gives us a good idea how long treasuries are trending.

This bond ETF has performed fabulously from last November to this past August, gaining 33% in just 9 months. Bonds don’t usually move anywhere near this much though, and as the yields got thinner and thinner, this could not go on all that much longer. Back in August, we told you that we’ve reached a point where the risk with bonds had reached a critical level and that bonds were now riskier than stocks.

While most people misunderstand the role that yields play in bond investing, where they think that higher yields are good and lower yields are bad after they are in a position, yields do matter to bonds but not in the way that we generally think.

Bonds Have Been on Fire, But the Fire is Now Smoldering

After we are in a position, we want yields to go down because this reflects higher prices for our bonds and therefore higher value. With a bond fund, you see shares in the fund rise as yields go down, even though the causation runs in the other direction, as the higher prices put down current yields for those who are entering at that higher price.

These yields may matter to those who are considering buying bonds though, although once again it is price that drives these decisions for the most part with yields just being another way of keeping score. Contrary to what some may think, the great majority of bonds are not bought with the intention of holding them to maturity, and if we even if it is possible that we may sell before maturity, price will completely dominate the decision, and in particular, how price may move, in our favor or otherwise.

Bonds achieving an annualized return of 44% over 9 months just isn’t sustainable, and not only that, we can’t even expect them to hold their value for very long after an event like this. We pumped a lot of air into the bond bubble during this time, and it then becomes just a matter of time before things normalize more, and having the price of bonds moving downward.

We might think that individual investors would be at least somewhat wise to this, especially with those investing in bond funds, but oddly enough, people don’t view bonds the same way as they view stocks. There have been masses of people worried about the end of the bull market with stocks, even though this has been far from an ominous threat, but these same people can miss the same thing happening with bonds, even when it is very ominous.

We could have even used the word inevitable at the top of this bubble, and we told you that entering a position back then really didn’t have much upside at all, and instead had significant downside. One of the comments that should have really stood out is our pointing out that there is a good chance that the price you paid in August may never even be revisited in your lifetime, meaning that you are virtually guaranteed to sell at a lower price even years down the road.

The reason why the upside was so limited is that there are structural forces with bonds that keep their prices from going up and up, and this does have a lot to do with yields. As the price goes up and the yields go down, bonds become pricier, and as they get more and more pricey, you get to the point where demand for them dwindles to the point where it peters out and you move the other way.

Once the bonds start selling, this creates downward momentum, where traders scramble to get out and to book profits. Getting the fabulous returns that bonds provided during their wild ride up only matter if they are realized, and watching anything go up a lot and then hang on to it as it goes back down isn’t the intention of these traders or anyone that wishes to act sensibly.

There is a lot of dead money involved here though, people who think that bonds are like stocks where you can buy them and forget about them and have a positive expectancy over time. Bonds trade in much tighter ranges than stocks do and do not accumulate capital gains over time, and therefore the timing of these investments becomes even more important. This is something that traders are wise to, but to the vast majority of individual investors, the very notion of timing bond positions is completely foreign to them.

Given the importance of this, this is not something that you want to be completely unfamiliar with, as this will play a significant role in your investing results whether you know it or not. Ignorance is not bliss with investing and it certainly isn’t with bond investing.

As expected, bonds have turned bearish and did so rather quickly once they peaked a few months ago. The iShares 20+ Treasury ETF is down 7% in only a little over 2 months, and there very well may be more in store here, quite a bit more actually.

When something goes up by 33% in 9 months, and we’re dealing with something that reversion to the mean is a real phenomenon that can’t be ignored, not paying attention to this downside risk even when it is slapping you in your face is a real bad idea.

We still haven’t fallen enough to make it down to July’s trading area with this fund, and the fund had shot up quite a bit to get to the July highs, so there’s plenty of potential for more, and a further loss of 7%, or worse, wouldn’t take that much. We only have a hint of progress with the trade talks with China, and as things progress further, this will visit the treasury market with more and more pain.

As Bonds Continue to Decline, We Should Be Winning, Not Losing

You can actually make money when bonds fall in price, by taking sell positions in the futures market or with contracts for difference trading, and while people usually think of this sort of trading as very high risk, when positioned correctly, this can reduce the risk, not increase it, because you are trading with the tide instead of being stationary and taking the full brunt of its force when it is flowing against you.

While you can take positions in the futures market using full leverage, putting all of your funds in play where both gains and losses can be multiplied 10 or 20 times, there is no requirement to do this, and you can even trade futures contracts without any leverage at all by allocating the full value of the contract in your account.

This makes going short bonds identical to going long by actually buying the bonds in terms of risk, where if they gain or lose 7%, so will you. There really isn’t another way to play bonds on the way down successfully, and this is something that many more people could benefit from being familiar with.

Short positions in bonds can also be used as a hedge in cases where you may not want to sell the bonds but still wish to be protected against downside risk. In times of trouble, people can actually fully hedge their long bond positions this way, where the gains from the short position can completely offset the losses on the long side.

Treasuries themselves don’t need to be hedged, other than seeking to be on the right side of them, but given that they don’t normally move that much in price, a lot of bond investors find them too tame and wish to spice things up by diversifying with riskier bonds. We then get bond funds that literally hold thousands of positions at one time, taking on more default risk than they should perhaps, given that the default risk of treasuries is so close to zero that they are deemed to be risk-free.

The U.S. treasury won’t be defaulting on bonds anytime soon, and while this will eventually happen, this is many years away. We will see a long and gradual breakdown of the treasuries market prior to this even having a chance of happening, and as long as people still buy treasuries, the government will just continue to do what it always does, which is to just borrow more to pay redemptions.

If we are looking to spice up our bond investments, the futures market provides lots and lots of opportunity to do this, as you can just use whatever amount of leverage you wish up to the maximum to achieve your target return. The maximum is well beyond what investors would be shooting for so there is all the room you need to do this.

Trading bonds on futures markets might also seem to be something that the shorter-term people get involved in, and those who would find holding a position for just a few months far too short for their tastes may allow this perception to steer them away from futures.

There are times where being in a position for a few months is very much appropriate, like with riding the wave up for these 9 months and then reversing and looking to make money as this buying wave subsides and the bears take over.

Those who do not wish to trade futures can instead invest in an inverse bond ETF. While those on the long side have lost 7% since August, those who switched to a similar inverse ETF have gained this much instead. It’s always better to look to stay on the side of the market, especially with this collapse being so substantial and so well telegraphed.

You don’t get the flexibility with ETFs as you get with futures, where you can ramp up your leverage by whatever degree that you are comfortable, trading bonds inversely even with ETFs at least provide investors with a means to not only avoid losses in bear moves but make money from them instead. This is a big advantage and one that the great majority of bond investors avoid due to a lack of understanding,

By using futures though, you can dial leverage up or down depending on the circumstances. This allows us to hedge stocks with bonds much more effectively, as this lets us control both the direction and the magnitude of the hedge simply by having more or less of the money we devote to this purpose in our futures account in play.

You can get away with selecting whatever timeframe you want with stocks, and this is because stocks go up on even the longest ones, but bonds are not at all like this and we need to let the market determine our length of holding if we want to invest in bonds well and not poorly.

If we are going to invest in bonds, we at least owe it to ourselves not to just do it mindlessly, and mindlessly perfectly describes how the majority of investors do it. You won’t get much good advice from your advisors since they are in the mindless club as well, and what we end up with is the blind leading the blind.

There are a lot of cliffs out there with bonds, just like the one in August, and even though we see a lot of people falling off it, to where we are now, with the strong possibility of falling even further, this doesn’t mean that we should be joining them. The worst thing about all this is that so few people even realize what is going on as we approach these cliffs or even realize that there are alternatives to doing nothing and just taking the punishment.

Treasuries remain bearish, and there are both some good opportunities to make or to lose money from this risk, and we do get to choose what side we want to be on.

John Miller

Editor, MarketReview.com

John’s sensible advice on all matters related to personal finance will have you examining your own life and tweaking it to achieve your financial goals better.