The Next Bubble: Bonds

3 06 2010

As an Objectivist, I see the massive amount of government intervention into the economy, the ridiculously low interest rates, and the ballooning amount of government debt and worry about the future of the economy. Inflation seems, if not inevitable, highly likely. As a value investor, I can’t bring myself to buy gold when it’s near or at its all time high. So I began searching for other hedges and I came across Seth Klarman’s strategy:

“To protect against that “tail risk,” said Mr. Klarman, Baupost is buying “way out-of-the-money puts on bonds”—options that have no value unless Treasury bonds plummet. “It’s cheap disaster insurance for five years out,” he said.”

As I began to look at treasury bonds (I don’t normally look at bonds very much), it became apparent that something very goofy is going on in the bond market. Look at the yield of the ten year treasury:

Besides the dip in ’08, the yield has not been lower since the data begins in 1962. And the story is the same for the 30 year treasury. The first thing that comes to mind when seeing this is BUBBLE! The yield on a treasury has to price current inflation, risk of higher inflation, risk of default, and a sensible rate of return into it. What is a sensible rate of return? I have no idea. But I do know that inflation has averaged somewhere between 3% and 4% since 1913. Well there goes the vast majority of the bond yield. And to think that we’re not going to have higher than average inflation is insanity.

Besides inflation, there is the risk of default. Of course, treasuries are thought of as risk free because the government can’t default. Despite this, Moody’s has discussed downgrading federal treasuries. Honestly, they’re not going to actually downgrade the treasuries. The government will just print its way out of default. So in reality, the default risk for treasuries is not gone, it’s just relocated into the ‘inflation risk’ category. Keep in mind that this is going on as the government is issuing an unbelievable amount of debt– bringing total American debt to $13 trillion.

People are buying gold, and driving it to record levels, because of the risk of inflation as well as the ballooning government debt. Gold provides safety from these risks (depending on what price you buy it at…). What safety does a government bond provide when it’s yielding such outrageously low rates? None. When two markets are so wildly out of sync, the markets are eventually going to HAVE to correct. Either gold is going down or treasuries are going down. However there are objective reasons for gold’s price. The same cannot be said about treasuries.

And this is why I’m a bottom up investor. Having realized a macro economic trend, it’s difficult to profit from it. I think I’m going to go the Klarman route and buy put options on ishares Barclays 20+ year treasury bond ETF (ticker TLT). I still have to decide which put options I’m going to buy, but I’m leaning towards a few that are way out of the money.

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