How to make a profit if bond prices drop
By
Paul Amery Nov 29, 2011
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If you’re an investor in the bond markets of peripheral eurozone member countries, you’ve been feeling the pain for months now. Rising yields have been in step with a steady fall of bond prices in Italy, Spain, Portugal, and now also France and Belgium. Greek bond prices have been on the mat for over a year, reflecting a likely default. But investors in UK gilts and US treasuries have seen yields fall to multi-decade lows, despite ballooning public deficits. This has wrong-footed some of the world’s best investors, PIMCO’s Bill Gross among them. Why?
Quantitative easing programmes (central bank purchases of debt) in both countries have underpinned bond prices. A flight to “safety” from troubled bond markets in the eurozone has also caused a surge of buying. As more and more countries go bad credit-wise, gilts and treasuries are among the shrinking pool of government-bond collateral deemed acceptable by market participants. In the weird world of post-credit-crisis finance, the ability to devalue one’s currency at will (which both America and Britain enjoy) is seen as a virtue.
But an old adage tells us that when central banks are buying, you should be selling (or vice versa). So contrarians might want to start looking at hedges against possible future declines in government bond prices. Two UK-listed db x-trackers exchange-traded funds (ETFs) allow investors to gain short exposure to British and American government bond prices. The db x-trackers UK gilts short daily (LSE: XUGS) and US treasuries short daily (LSE: XUTS) ETFs produce a daily return that is the inverse of a broad basket of each country’s government bonds.
Each fund carries an annual expense ratio of 0.25%, and there’s a further 0.4% per year built into each underlying index to reflect the cost of shorting. Inverse (short) ETFs also rebalance their exposures daily, causing returns to “drift” over time from a simple inverse of the equivalent long index return. So before using such a fund, you should fully grasp how it works (for more, see www.moneyweek.com/ETF). These are also relatively small and infrequently traded funds. It’s therefore a good idea to use limit orders to buy and sell, placing your execution price within the prevailing bid-offer spread to try and cut costs. All these caveats may put you off. But if you want to benefit from possible future falls in UK and US bond prices, these funds are among the easiest ways to do it outside of spreadbetting.
• Paul Amery edits www.indexuniverse.eu.
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