Will This Investment Finally Pay Off?
The big move up in stocks over the past several days has had many investors sighing in relief. But the recent move has led one long-suffering group of investors to make yet another call for interest rates to rise -- a call that many market professionals have gotten wrong for a long time.
A tale of two markets
You're probably all too familiar with how jumpy the stock market has been recently. Although the past week's climb has added 750 points to the Dow Jones Industrials (INDEX: ^DJI), it still hasn't come close to putting the market on the same footing it had before the August and September slump. Even after a strong recovery following the market meltdown in early 2009, investors still don't feel comfortable committing their money to stocks for the long haul.
But throughout all the financial turmoil in the world in recent years, there's been one bull market that investors seemed to depend on through thick and thin: the bond market. In particular, Treasury bonds have defied everything from massive deficits to the debt-ceiling crisis and a Standard & Poor's downgrade, and their prices still remain near record highs.
Making the wrong call
The latest sign of bond bears comes from the universe of exchange-traded funds. TheWall Street Journal reported that last week, the ratio of bearish options bets against the iShares Barclays 20 Year Treasury Bond ETF (NYS: TLT) reached its highest level in two years. At the same time, the bearish ProShares UltraShort 20 Year Treasury ETF (NYS: TBT) has seen investors buying call options, betting on a move up for the ETF, which represents a double-leveraged bet against rising Treasury prices.
In addition, corporate issuance has started to slow down, suggesting that companies can't compete with Treasuries. Although high-quality issuers Intel (NAS: INTC) and Hewlett-Packard (NYS: HPQ) managed to get deals done, the third quarter saw a drop of about 40% from the previous quarter, and spreads for corporate bonds rose dramatically over rock-bottom Treasury yields. That suggests that either corporate yields will have to fall, or Treasury rates need to rise.
The problem, though, is that we've seen all this before. Bill Gross fell prey to the phenomenon earlier this year, as he was convinced that Treasuries would have to drop. Yet when he drastically reduced his bond fund's exposure to Treasuries, the fund's returns fell into the lowest echelon in its peer group, leading Gross to reverse course.
Gross wasn't the first to fall, though. Bank of New York Mellon (NYS: BK) and Barclays (NYS: BCS) cut allocations to bonds by a quarter to a third earlier this year. Many other bond mutual fund managers think bonds aren't a compelling buy right now, despite their obvious financial self-interest in having investors buy shares of their funds.
A dangerous investment
Sure, buying long-term Treasuries when their rates are so low doesn't make sense for most investors. But trying to bet against them with leveraged ETFs is really risky. In just over three years, the ProShares UltraShort Treasury ETF has lost more than 70% of its value -- and nearly half its value just since January.
Similarly, options plays with ETFs require not only that you be right about the direction of the bond market but also on the timing of an eventual move. With the Federal Reserve seemingly in command of interest rates until mid-2013, it's entirely possible that central bank intervention will prevent rates from rising -- potentially hurting bond bears yet again.
Be careful out there
Don't get me wrong: I'm not saying that Treasury bonds or bond ETFs are a good buy right now. Indeed, over the long run, I still believe that investors who blindly buy bonds will get burned. But betting the farm on an immediate break of a bull market in bonds that has lasted for decades could easily end up costing you everything -- even if things eventually work out the way you expect.
Just because leveraged bearish bond ETFs aren't your best bet doesn't mean you should give up on ETFs entirely. Take a look at The Motley Fool's free special report on ETFs for some great ideas on where to get started.
At the time this article was published Fool contributor Dan Caplinger was years early in his bet on higher Treasury rates. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Intel. Motley Fool newsletter services have recommended buying shares of and creating a diagonal call position on Intel. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy pays off for you every day.