As Treasury bonds tumble, short ETF sparkles

If you’ve been waiting for an entry point to UltraShort 20+ Year Treasury ProShares (TBT), it has arrived. Prices of long-term Treasury bonds, which move opposite to this exchange-traded fund, are falling as interest rates rise. This story can continue for months.

Yesterday the spread between yields on long- and short-term bonds set a record. In market parlance, that means the yield curve is strongly positive. That’s an indicator of economic vitality. But a steep yield curve means high yields on long-term bonds, and prices move opposite to yields. All long-term bonds are disadvantaged in this regime, but Treasurys are most vulnerable because their only risk is rising interest rates.

TBT was trading this morning at $49.72. That’s up 7.1% in the last month, and 30.1% this year. The ETF is designed to move twice as much as the index it mirrors, which is the current market behavior of long-term Treasury bonds.

As of this morning, two-year Treasury notes were yielding 0.88%. The yield for 30-year Treasury bonds was 4.62%. The difference between these rates–3.74 percentage points, or 374 basis points–is the spread. At the depths of the late recession it was relatively narrow, and several times actually turned negative,  meaning long rates were lower than short rates.

Short-term interest rates are set arbitrarily by central banks; in the United States, by the Federal Reserve. They are currently at historically low levels as the Fed tries to encourage borrowing to combat economic weakness.

Long-term interest rates are set by the bond market, and have been relatively low because borrowing has been extremely weak. The fact that long rates are moving higher means borrowing has increased and lenders are discovering they can get higher returns on loans because competition for them has risen.

If long-term interest rates were to rise 100 bips, or 1 percentage point, the price of a long-term Treasury bond in the index this ETF mirrors would go down 15.3%. This relationship between price and yield is purely mathematical, a function called duration. An investor in these bonds gets his principal back in 15.3 years.

Since the UltraShort bond is leveraged two times against the index, it should rise 30.6% in this example. In fact it would not. The leverage is applied daily, and compounding over time leads to tracking error, which can be substantial; 10% up and 10% down are two different quantities.

Also the fund’s fees, a hefty 0.95%, subtract directly from performance.

But assuming the ETF is held for a few months or less, it should move opposite to the Treasurys themselves, and by roughly twice as much.

Fortunately for shareholders of this ETF, tracking error increases with volatility, and Treasury bonds are one of the least volatile investments. But they are an investment, not a savings certificate, and a leveraged ETF is riskier than a plain-vanilla alternative. In this case, however, there is no unleveraged short-Treasury ETF.

What could go wrong with this thesis? The recession could come back, borrowing could collapse and long-term interest rates could tumble. Treasurys are universally regarded as a safe haven. A sudden collapse of stock prices could send investors fleeing equities into bonds, driving up their prices.

In the macabre world of fixed-income investing, good news is bad. A strong economy batters them because it drives up rates, which drives down prices. So bad news is good for bonds–which means it is doubly bad for TBT. Buying TBT means you are betting on a stronger immediate future. I think that’s a good bet right now, and I own this ETF.