January 16th, 2010

Short TLT Rather Than Be Long TBT

There’s been a lot of focus of interest rates recently as they finally start edging higher because of the magnitude of the Federal deficit. For example, the NYTimes, in an article entitled “For ‘Safe’ Investors, This May Be a Challenging Year”, pointed out that

“There are many indications that this herculean intervention has been working. In the bond market, though short-term interest rates are still hovering near zero, longer-term rates have been on an upward trajectory since late November….”

but

“Liquidating investments that pay almost nothing in order to shift to long-term bonds that pay substantially more may not make sense right now, said Robert F. Auwaerter, the head of fixed-income investing at the Vanguard Group….interest rates — at both the short and the long ends of the yield curve — are likely to rise this year if the economy keeps expanding…..When bond yields rise, their prices fall. The effect is magnified for longer-term securities, so a 30-year Treasury bond would fall in value much more sharply than, say, a six-month Treasury bill.”

While fixed income investors may be enticed to switch from the ultra-safe but low yielding money market accounts to higher-risk, higher yield long-term bonds, we stock and ETF investors have another possible trade.

Many recommend the purchase of TBT, the Proshares Ultrashort 20+ Year Treasury ETF (in full disclosure, I’ve owned TBT since August after writing about it last August in “Life Insurance Stocks: GNW, HIG, LNC, AZ, PFG and Others). This ETF purports to be a mirror image of the trend of 20+year Treasury bonds. As long-term interest rates edge higher, long-term treasury bonds should, theoretically, decline in price. Being an “ultrashort” ETF means that the price of the ETF should increase in value at twice the rate at which the average price of 20+year bonds decrease in value.

The reciprocal of the TBT is TLT, the iShares Barclays 20+ Year Treasury Bond Fund. This ETF mimics the long-term interest rates. When interest rates decline, TLT increases in value; when rates increase, TLT should follow bond prices and decline.

Investors who want a quick and easy way of playing an expected increase in interest rates would be either to buy the TBT or short the TLT (or buy calls or puts, respectively). So I thought I’d check out how these two ETF’s have performed over the past year and a half, since Labor Day, 2008:

I created an index for the values of each of TLT, TBT and 20+year interest rates with August, 25, 2008 set to 1.00. The scale for TLT (the “long” ETF for 20+year bonds in red) is on the left while the scale for TBT (in blue) and interest rates (in green) is inverted on the right-hand side of the graph.

I was shocked. While interest rates and TLT work very closely together (by the way, cumulative dividends paid on each of the ETFs were added back in order to show a true total return for the period), TBT has been falling far behind. Interest rates on 20+year Federal debt today is about at the same level it was on 8/25/ 2008 and TLT (after cumulative dividends are added back) are at the same level as they were on 8/25/2008. On the other hand, TBT (after its only dividend of 9/24/08 was added back) is 25% less than it was on 8/25/2008.

While TBT and TLT correctly work (in opposite directions from one another), the volatility of TBT falls behind that of TLT. This may reverse in the future and TBT may catch up with TLT but someone looking at interest rates rising over the next 6-9 months or more could have better results shorting TLT than buying TBT, even if the latter is supposed to be twice as volatile as the underlying security.

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  • John Robbart

    I see what happens but I don't understand why. Can you explain in words how this can be?
    Thanks

  • John Robbart

    I have already bought a call option on TBT that is 18 months out. It has lost value. Perhaps this is why.

    Do you have any suggestions other than just taking my loss and chalking it up to costly education?