How to Play the Coming Bond Bust

The Treasury bond bears are out and about—and getting bolder. On Mar. 9, Pacific Investment Management's Bill Gross announced that his $237 billion Total Return Fund, the world's largest bond fund, had shed all U.S. government securities. Short interest in long-dated bond exchange-traded funds (ETFs) has ballooned since the start of 2011, while bank-loan ETFs that use leverage and are therefore exposed to interest rate risk have come under pressure in recent weeks. Behind these moves is a bet that interest rates will rise soon, lowering the value of existing longer-term bonds.

Some strategists have warned that demand for Treasurys by Japan, the second-largest foreign holder, will likely drop as the Japanese government marshals funds for a massive post-earthquake rebuilding effort. Jim Caron, global head of interest rate strategy at Morgan Stanley (MS), said on Mar. 17 in a Bloomberg Television interview that he believes it's more likely insurance companies will cover damages out of premiums, rather than by selling Treasurys.

The earthquake sparked a drop in Treasury prices as investors, anticipating future sales by Japan, rushed to sell. Yields are expected to rise in the second half of 2011, after the Federal Reserve's quantitative easing program has ended. Most economists don't expect the Fed to start raising rates until the end of 2011, and some believe the hikes may not begin until the second half of 2012.

Bond investors are hard-pressed to find decent yields without assuming more risk these days, with interest rates at historic lows and cash vehicles such as money market accounts paying virtually nothing. Investors are also wary that rate hikes will eventually harm the value of existing Treasury debt. This environment has stirred short interest—or bets on a selloff—in long- and intermediate-dated Treasurys. Year-to-date as of Mar. 9, $800.53 million had flowed into these short positions, compared to a net outflow of $19.55 million in the same period a year ago, according to data compiled by Marco Polo XTF, a New York-based ETF data provider.

All Eyes on Signs of Inflation

While bets against longer-dated Treasurys may seem premature, given the current low inflation rates and the prospect of high oil prices denting growth, a rise in inflation expectations is just as worrisome to investors, says Nicholas Colas, chief market strategist at BNY ConvergEx Group. That's why economists are paying such close attention to recent spikes in oil and food prices before they can start feeding into the core inflation number. Core inflation remains low—at a year-over-year rise of 1.1 percent in February—with gains expected to remain around 1 percent through the second quarter, despite further big headline price gains, according to Action Economics. "Inflationary expectations are well-grounded right now, but that can change if people become more accustomed to paying more for the basics of life," Colas said.

Bill Larkin, a fixed-income portfolio manager at Cabot Money Management in Salem, Mass., believes interest rates could rise by a couple of hundred basis points later this year if the Fed's support for long-dated bonds ends on schedule in June, as Federal Reserve chairman Ben Bernanke has announced. This has prompted Larkin to move a bigger portion of client assets into cash as a defense, given his view that smaller premiums to the yields on Treasurys with comparable maturities render most other debt products less attractive. Many strategists, including Larkin, say that even if investors expect rising inflation, they can't afford to hold large cash positions for an extended period and should own bonds that offer slightly higher returns. Larkin has been buying Ginnie Mae bonds yielding 5 percent to 6 percent—200 to 300 basis points above Treasurys of comparable maturity. (Ginnie Mae is the shorthand name for debt issued by the federal Government National Mortgage Assn. (GNMA), which pools mortgages purchased from banks.)

The process of buying individual U.S. agency bonds is often too complex and inconvenient for individual investors. In the search for additional return without too much extra risk, a handful of short-term government bond ETFs can be suitable, says Timothy Strauts, an ETF analyst at Morningstar (MORN). These aren't meant to be long-term holdings but can help boost income generation until higher interest rates return. The Vanguard Short-Term Bond ETF (BSV) tracks the performance of the Barclays Capital 1-5 Year Government/Credit Index and holds both government and corporate debt. The current yield is 2.2 percent and the 2010 return was 3.8 percent. Barclays' market-weighted index consisted of 70.97 percent government bonds and 29.03 percent corporates as of Mar. 16.

IShares Barclays Agency Bond

For government agency debt similar to what Larkin recommends, there's the iShares Barclays Agency Bond (AGZ), which holds Fannie Mae and Freddie Mac notes with an average maturity of 3.6 years. With an expense ratio of 0.20 percent, its current yield is 1.87 percent, lower than it was a few years ago because of the explicit U.S. government guarantee for such debt.

ETFs made up of inflation-protected Treasury securities, such as the PIMCO 1-5 Year U.S. TIPS Index ETF (STPZ), are another option. The Pimco ETF tracks the Consumer Price Index more closely than the iShares Barclays TIPS Bond ETF (TIP) does because it owns shorter-term bonds, says Strauts at Morningstar. In December, iShares launched its own Barclays 0-5 Year TIPS Bond Fund (STIP). The problem with TIPS ETFs, says Cabot's Larkin, isn't how closely they track CPI, but CPI itself, which he said underestimates real cost-of-living increases by excluding food and energy and overweighting housing. That depresses the yield and makes TIPS poor income-generating vehicles. Larkin prefers the SPDR Deutsche Bank International Government Inflation-Protected Bond (WIP), which tracks a basket of non-U.S. government inflation measures. The countries it tracks, including the United Kingdom, France, and Mexico, tend to report higher inflation, so investors at least get "a fair and reasonable return" for lending their money, Larkin says. WIP had a return of 6.56 percent in 2010 and 17.14 percent in 2009, outperforming U.S. TIPS ETFs in both years.

Currently, the market is focused on avoiding longer-term maturities. More important is whether the difference between rates for 2-year and 10-year Treasurys is widening or narrowing, says Ira Jersey, director of the U.S. Interest Rate Strategy team at Credit Suisse (CS). On Mar. 17, those yields were 0.55 percent and 3.17 percent respectively, for a spread of 2.62 percentage points. The yield curve typically steepens with economic growth but reached a historic high of 2.91 percent a few weeks ago. "Once it becomes apparent that the Fed will be [raising rates], the curve should flatten quite dramatically," Jersey says.

There are two exchange-traded notes that investors can use to make money on the spread between the 2-year and 10-year Treasurys, depending on its direction. The iPath U.S. Treasury Steepener ETN (STPP:US) tracks the Barclays Capital U.S. Treasury 2Y/10Y Yield Curve Index and gains when the spread widens. The iPath U.S. Treasury Flattener ETN (FLAT:US) tracks the inverse of the index and gains when the spread narrows. Since the yield curve moves in cycles, owning one of these "can make a lot of sense" for anyone trying to hedge their fixed-income portfolio, Strauts says.

Big Debut: PowerShares Bank-Loan ETF

Growing expectations that interest rates will rise in the next 12 months are also driving money into short-term, nongovernment debt such as floating-rate senior bank loans, which are short-term loans made to companies that can't access the capital markets. Invesco (IVZ), which manages more than $18 billion in this asset class—much of it in institutional portfolios—on Mar. 3 launched the first bank-loan ETF, the PowerShares Senior Loan Portfolio (BKLN). The fund tracks the Standard &Poor's 100/LSTA U.S. Leveraged Loan 100 Total Returns Index, which is made up of the largest and most liquid corporate issues within the broader S&P/LSTA Leveraged Loan Index. First-day volume was about 1.5 million shares, worth a total of $37 million, dwarfing the few thousand shares that most ETFs trade on their first day, Strauts says.

Because they're issued by junk-rated borrowers, senior bank loans carry more risk than Treasurys and investment-grade corporate debt. There's some comfort in knowing that they're fully collateralized, backed by the borrower's physical assets. That puts them at the top of a company's capital structure and places investors ahead of fixed-rate bond holders if the company files for bankruptcy. In 2008, this market tanked on widespread fear of defaults, since so many leveraged loans were issued by private equity firms that had overpaid for the companies in leveraged buyout deals. The S&P Leveraged Loan Index has recovered nearly all of its value since then and posted a negative return in only one year—2008—since its inception in 1997. Van Eck Global is the only other ETF provider to announce plans to launch a bank-loan ETF.

Ultimately, bond investors must choose between returns or safety. If it's safety, short-dated government bonds will do the job while not earning much. For decent returns, one needs to look toward corporate debt—whether it be in bank loans, high yield, or preferreds. Here's the silver lining: With federal deficits ballooning, the paradigm has shifted, reducing the risk of corporate debt relative to that of Uncle Sam's obligations.

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