Time to Bet against Bonds?

You can short-sell them, just as you would stocks. Here are some simple and not-so-simple ways.

You know bonds are about to fall when one of the best bond-fund managers wishes he could bet against them. "The bond market is a short [sale] candidate," says Robert Rodriguez, whose fund, FPA New Income, has never had a down year since he took charge in 1984. "Since this fund can't short, we're holding a lot of cash in our portfolio to protect ourselves."

Rodriguez can't short bonds, but you can. While many individual investors short stocks -- sell borrowed stock with the expectation of buying it back cheaper -- they don't often do it with bonds. Nevertheless, to Rodriguez and others, shorting bonds is the next fat pitch. "When the yield on the 10-year Treasury hit 3.57% on Mar. 10, bonds were as overvalued as the stock market was in the spring of 2000," he says. (A low yield means a bond's price is high because prices and yields move in opposite directions.)

FLOODING THE MARKET

Treasury prices dropped when the prewar stock rally prompted investors to sell bonds to purchase stocks. They have rallied a bit once the prospect for a weeklong Gulf War faded. The 10-year Treasury note now yields 3.8%, but odds are that bond prices will decline anew when the shooting stops.

Why? Commodity prices in general, and energy prices in particular, have been soaring in the past 12 months. That trend can be inflationary, especially if the long-awaited economic recovery kicks in. Bond investors sell at the first whiff of inflation because it makes the income they get from the securities less valuable.

Even without a bout of inflation, the outlook for bonds is clouded by the mounting U.S. budget deficit. After four straight years of surpluses, the deficit in 2002 hit $158 billion, an amount that the Congressional Budget Office expects to more than double by 2004 as costs of the war, reconstruction, and tax cuts kick in. Such shortfalls prompt the government to issue more bonds and flood a market where investors are already loath to buy -- especially foreign investors, who are now losing money in U.S. bonds because of the sinking dollar.

So how do you short bonds? The simplest approach is to let a mutual fund do it for you. Two funds, Rydex Juno and ProFunds Rising Rates Opportunity, bet against the 30-year U.S. Treasury bond. Rydex (rydexfunds.com) employs a standard short position. The firm borrows bonds from a broker, then sells them and holds the proceeds in a margin account. If the bonds decline, the firm buys them back at the lower price, returns them to the broker, and can claim as profit the difference between the amount they originally borrowed and sold and the cost of buying back the bonds.

ProFunds (profunds.com) employs a more complex approach, involving contracts with banks that promise to pay the fund the inverse of the Treasury's return. The fund also leverages its bet, delivering 125% of the inverse of the long bond's daily performance. So if Treasury prices fall 1% in a day, the fund would rise 1.25%, and the reverse if prices rise.

That said, the best short opportunities may not be in the 30-year bond. The yield curve, which measures the payouts of bonds of different maturities, is "steep" right now. That's because of the yawning gap between the yield on the 30-year bond, about 5%, and the five-year note, which yields less than 3%. With a steep yield curve, the shorter maturity bond is often the more overvalued.

If you want to short the five- or 10-year notes, you'll have to open a margin account with a broker. Don't short the bonds directly, though. Brokers usually charge high markups on small quantities of the securities. A better strategy is to short an exchange-traded fund (ETF) that invests in bonds. Since ETFs trade just like stocks on public exchanges, there is no bond markup. For instance, ETF Advisors Treasury 5 FITR tracks a portfolio of five-year Treasury notes. (For more information on bond ETFs, go to ETFConnect.com).

Shorting can be hazardous if done incorrectly. Margin accounts generally require that you hold at least 50% of the value of your short position as collateral. If the security starts to move against you -- it rises instead of falls -- your broker may require you to add funds as collateral or force you to liquidate the short position.

DEFRAYING THE COSTS

Also, you must cover the interest payments on the bond ETFs you've borrowed in the short position. So if the 10-year note yields 3.8%, you have to pay that plus the broker's margin rates, which can range between 4% and 8% of the loan's value. That may sound costly, but, remember, you have to put up only half the amount of the short sale. The other half you could invest in some other fixed-income investment to cover your costs.

For instance, say you sell short 100 shares of the 5-year Treasury ETF. At a recent price of $85.60, that puts $8,560 (before commissions) in your margin account. You'll also need to have at least half that amount, $4,280, in the account as collateral. All told, you have $12,840.

You could invest another $4,280 in interest-bearing securities in a separate account to help defray your margin costs and the interest payments for the bonds you sold. A bold tactic would be to invest that cash in a high-yield bond fund, which could yield anywhere from 8% to 12%. Why? Junk bonds are considered cheap relative to Treasuries. And an economic recovery that would push interest rates higher would also improve the credit quality of high-yield bonds. Periodically, you would take a portion of your high-yield interest and deposit it in your margin account in case your collateral dips in value.

Shorting can be risky, but if you would do it with stocks, you might as well try it with bonds. They are less volatile than stocks, so the risk of large losses is not as great. Back in the salad days for stocks, no one ever thought they could fall, either. Now might be an opportune time to bet against bonds.

By Lewis Braham

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