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Monday, March 1, 2010
Possible chance

There are a growing number of voices calling for the shorting of global bonds. Some, like Marc Faber, have called it the short of the century. Nassim Taleb, well known author and previous derivatives trader, reportedly said that “every human being should bet that US treasuries will decline”.

Explains Ian de Lange of Seed Investments, “Normally a government or large corporate wishes to borrow money. It issues bonds at various interest rates and with various redemption periods. The rate at which they can borrow depends on prevailing market rates, which in turn is also driven by supply and demand.”
One of the reasons that so many people are calling for investors to short bonds is that the borrowing requirement at the government level of developed economies has risen sharply. With government spending up and tax collections down governments need to borrow more.
‘Selling short’ means a trader sells, in this case, bonds which he does not own and contracts to cover his needs by buying them in the future. Provided the market goes the way all these experts are predicting then he will make a profit since he will pay less for the bonds he eventually buys, than the ones he sells now (by selling short).
This month, the US administration released its latest budget outlook, which forecast a fiscal deficit of US$1.55 trillion (10.6% of GDP) for 2010 financial year and US$1.3 trillion (8.3% of GDP) for the 2011 financial year.

The chart indicates the extent of the growing problem: US Budget deficit as a % of GDP
Source: Coronation and Congressional Budget Office

Annual fiscal deficits (i.e. fewer inflows accumulate as debt). The increased supply of debt theoretically means that investors will demand higher yields.
Where yields rise, existing lenders suffer capital losses. Conversely as interest rates decline existing lenders enjoy capital gains.
“Therefore if the assumption is that interest rate yields should rise in future to take into account the increased supply and debt load of the governments,” says De Lange, “then the correct trade will be to sell bonds short at current yields and buy them when the yield increases (price declines).”
This is not foolproof. The 10 year treasury in the US is currently yielding a nominal 3,56%. Lending money to the US government has traditionally been viewed as one of the safer options for investors because of the almost guaranteed nature of the returns.
So in times of global uncertainty, money has sold out of risky assets and found its way into government bonds. We saw this in 2008 and again over a few days early this February where global markets had been under pressure, this is exactly what has happened, resulting in yields coming down slightly and investors making profits on bonds.

Investors wanting to short US bonds are also wary of a repeat of the Japanese scenario. Over many years with anaemic growth and deflation, bond yields on 10 year Japanese bonds slumped to around 0,45%.
Low yields on what has traditionally been safe investments do not make it easy for investors. “It complicates matters where some are now saying that the way to make money is to short these traditionally safe haven investments. This is truly not a simple investing environment.”

Copyright © Insurance Times and Investments® Vol:23.3 1st March, 2010
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