Wall Street continues to digest the latest round of comments from Ben Bernanke and the Federal Open Market Committee, but the bond market is making a pretty clear case that it’s starting to plan for higher rates in the not-so-far-off future.
During the past few weeks, yields on the 10-year Treasuries have gapped up above the 2% mark. The last time we saw yields rush to this level was in March — a rise that eventually receded as the Fed pushed the timeline for its “tapering” off to 2014 or later.
For much of the past two years, we’ve watched bond funds and ETFs swell in size as investors searched for yield-bearing investments and tried to avoid market volatility. The result of these years’ worth of pumping is a potential bubble in the bond markets. Here’s how things could play out:
Investors’ attention will turn to the yield on 10-year Treasuries ($TNX), which is climbing above 2% (red line in the chart below), remembering that the market often leads the Fed in raising rates.
At that time, a hard lesson about the relationship between bond yields and values will commence as the value of bonds on the longer end of the curve will see a decline, putting pressure on those investors that plowed money into bond funds to retrace their steps. As these investors figure out that a 5% yield does you little good if your principal is declining at twice that rate, they will withdraw those same funds, deflating the bubble in the majority of bond funds.
So, what’s an investor with bond exposure to do?
For now, with a potential increase in bond market volatility, we’re looking at hedges against bond value declines as a reasonable move. Fortunately, the mutual fund and ETF markets offer easy tools for something that sounds difficult.
Rydex Inverse Government Long Bond Strategy Fund
Rydex Funds is known for specializing in vehicles to target performance in index and sector moves, including funds for bears. The Rydex Inverse Gov Long Bond Strategy Fund (RYJUX) seeks to provide returns that inversely correlate to the daily price movement of long-term U.S. Treasury debt. For now, this fund offers a hedge for investors that might have a large portion of their portfolios dedicated to bond holdings.
For those investors looking for a more aggressive move than a simple hedge, the ProShares UltraShort 20+ Year Treasury ETF (TBT) offers a leveraged inverse investment against long-term Treasuries. Specifically, this fund seeks to provide daily performance that is two times the inverse of the Barclays U.S. 20+ Year Treasury Bond Index. Just be aware of the potential dangers of such leveraged products.
As of this writing, Johnson Research Group did not hold a position in any of the aforementioned securities.