ETFs That Short Treasurys Suffer Big Losses

(Dow Jones) Betting against Treasury bonds was supposed to be the no-brainer strategy for 2010. Instead, shorting government debt has brought steep losses so far this year, due to surging bond prices as investors seek safety on worries stocks could be hit by deflationary headwinds.

The largest exchange-traded fund tracking the long end of the Treasury curve, the $3.3 billion iShares Barclays 20+ Year Treasury Bond Fund (TLT), has rallied more than 10% year to date. The ETF rose Friday in the wake of a disappointing July employment report.

At the same time, a leveraged ETF designed to profit from falling Treasury prices, ProShares UltraShort 20+ Year Treasury (TBT), has lost more than a quarter of its value as yields have ticked steadily lower-bond prices and yields move in opposite directions.

The Direxion Daily 30 Year Treasury Bear 3x Shares (TMV), which pours on even more leverage, has shed close to 40% so far this year.

Yields on the 30-year bond have compressed to about 4% as investors grow more skittish on stocks.

"Treasurys are supposed to be boring, low-return assets for retirees and the risk averse," said Nicholas Colas, ConvergEx Group chief market strategist. "Instead of playing bridge or canasta with Grandma, however, they have been the 'Cinderella story' of the capital markets this year."

Broken Over Bonds

The rally in Treasury bonds has been painful for many investors who took the other side of the trade. For example, assets in the ProShares UltraShort 20+ Year Treasury have vaulted to nearly $4.5 billion.

So far, the jump in Treasury rates that many predicted has failed to materialize. One key piece of the bearish thesis for bond prices is that government spending and deficits to fight the economic downturn are unsustainable, and that ultimately investors will demand higher rates to compensate for the risk.

Treasurys are in a bubble that could quickly unwind as rates rise or if investors rediscover their appetite for risk and move out of "safer" government bonds, the case goes. Some analysts worry supply could ultimately outstrip demand amid unprecedented issuance of Treasury bonds.

On the other hand, Treasury bulls argue that yields can decline even further as markets fret over signs the economic recovery is losing steam, raising concerns over the prospect of a double-dip recession.

Falling yields have "confound[ed] many who have long asserted 'out of control' government spending will cause bond vigilantes to drive yields higher," said Dan Greenhaus, chief economic strategist at Miller Tabak, in an Aug. 3 note.

Other factors favoring lower bond yields are the absence of any meaningful inflation in the CPI numbers and expectations that the Federal Reserve won't be raising interest rates anytime soon.

Interest-rate futures suggest there's little chance that the Fed will increase its target policy rate before June 2011. On Friday, Pimco's Bill Gross told Bloomberg it is doubtful the Fed will raise rates within the next two to three years as it tries to prevent the economy from relapsing into recession.

The Fed's policy-setting FOMC meets this week. There has been talk the Fed could engage in a fresh round of so-called quantitative easing to help the economy, such as using its balance sheet to purchase bonds, including Treasurys.

Also, any flare-ups in Europe's sovereign-debt crisis could stoke the flight-to-safety trade and push bond prices higher. Indeed, Treasurys were one of the few investments that provided cover from the credit storm in 2008. With many assets moving in lockstep, some say Treasurys are one of the last diversifiers left for stock investors.

The iShares Barclays 20+ Year Treasury Bond Fund was a safe harbor in 2008 as the ETF gained 33.9% in a year that saw the SPDR S&P 500 ETF (SPY) dive 36.7%, according to investment researcher Morningstar Inc.

Finally, the specter of deflation is a powerful influence driving many investors into bonds as the world deleverages after the credit binge. Companies and individuals are saving more rather than spending, and the unemployment rate remains stubbornly high.

Reflecting these fears, investors are piling into bond ETFs and mutual funds, and shying away from equities.

"After lingering in the background of the ETF industry for the last several years, fixed-income funds have stepped up in recent months to become one of the primary drivers of growth," according to ETF Database analyst Jared Cummans.

"Through the first seven months of 2010, cash inflows to ETFs totaled $49 billion," Cummans said. "Of this amount, more than $23 billion has been attributable to fixed-income ETFs, reflecting that investors have become increasingly comfortable with the idea of achieving their fixed-income exposure within the ETF wrapper."