Wednesday, December 31, 2008

Time to Short the Government?

If you have been dumbfounded by the size of the ever-expanding federal deficits and crony bailouts, you are not alone. May be you are even more surprised at the low yields of the government paper: the on-the-run 30-year note dropped under 3% recently. In other words, there is someone out there willing to give Pelosi & Co. a 30-year loan for 3% a year.

Truth is stranger than fiction sometimes.

I passed on the deal when I got the call from the syndicate, haha. Remember the government does not have the money (by a long shot) that it actually spends on the budget, the wars, the bailouts and the stimulus. It simply enslaves the producers of future generations via higher taxation and/or a lower standard of living.

There are a couple of other (very basic) issues to consider with sovereign debt, and debt in general.

(1) One is that as a creditor, you do not want to lend to someone in their own currency. They can simply print it out and "pay" you nominally. This is the reason most of the second- and third world debt is dollar-denominated. The US used to have predictable policies but now it seems that the presses are running out of control. As a creditor holding dollar-denominated debt, I would be very worried.

(2) The second issue, quite basic (but as a nation we seem to have forgotten the basics in so many areas), is the 5-C's of credit: character, capacity to repay, collateral, capital and conditions (of the loan).
Do a quick mental rundown on these: character (the borrower cheats by printing own money, top politicians and administrators have questionable- at best- behaviors and IQ), capacity to repay (nominal, yes; real, not so much, deficits to grow structurally for the next 80+ years), collateral (none pledges thus far: think land, drilling rights, highways), capital (balance sheet of an extra large sieve, lots of liabilities off-balance sheet) and conditions (is the money used for something productive? absolutely not: government spending is inefficient by default, and most spending goes to "entitlement" programs; who entitled someone else to the fruits of the taxpayer labor is beyond the scope of this post).

Is the low-interest environment going to last? Probably not. How can an individual investor play this? There are two high-volume reverse ETFs for government bonds: TBT and PST. TBT 2x shorts the 20+ year instruments, and I like it better. The PST shorts 2x 7-10 year bonds. Both are listed under the "ProShareUltraShort" label of products.

If rates are going to rise (there is no doubt in my mind they will), the longer bonds are more sensitive to interest rate changes. Remember that they have longer "duration". A 10-year bond, with a 3% coupon and a 3% yield has a (m) duration of 8.6 yrs, and is priced at 100, of course. If rates go to 6% (not unthinkable), the price will drop to 77.7, if my calcs are correct, and the bond duration goes down to 8.2 yrs. I would guess that the index PST shorts has bonds of slightly lower duration.

If you have the same 3% yield/3% coupon payments on a 30-year bond, the (m) duration is 19.7 years, and the price is, again, 100. If the yield goes up to 6%, the price would then drop to 58.5 and the (m)duration would go down to 16.1 yrs. The price change in the index that TLT shorts 2x would not be as high as it does 20+ years, not just the 30-year.

If you have MS Excel, you can check those out yourself: =price(settlement, maturity, etc.) and =mduration(settlement, maturity, first coupon date, etc.). The quickest way is to do price( press shift+F3, and select the cells or fill-in.

What can go wrong? A lot, of course. A substantial market sell-off can really drive the yields down even further. This drives bond prices higher, and you get hit. Don't also forget that the SEC may decide to ban shorting bonds. I would not be surprised after the friends-and-family do not short list. Also if the Fed is a buyer, the real price discovery will be delayed. Just like with the price discovery on a lot of other assets. Then there are the issues with the 2x funds that are well-documented around the investment blogosphere. And, right now you've got deflation which means that the low rates might be around for a longer than most people think. And then there is the theory that as there are less inflows from Asia, the US consumer will start saving more and this will replace the demand. I doubt the last part: most will probably go towards paying down credit card debt. You can also have a move across the curve that is not parallel, meaning that the price change on the long bond can be smaller than that of the 10-year.

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