Should You Buy Treasuries?

Source: http://www.flickr.com/photos/23165290@N00/

In January I wrote an article in which I argued that investors should consider owning U. S. Treasury bonds as a trade. I emphasized that I understood the long-term bearish case that interest rates are way too low and that an ever-increasing supply of government debt would inevitably put pressure on prices. Nevertheless, Treasuries closed 2013 at a low point.

Furthermore, sentiment was awful. It seemed that no matter what position you held, it followed that you had to be bearish on government bonds. If you felt the economy was improving, then investors were supposed to take their money out of bonds and put them into stocks. If you felt that the economy was weakening, then government debt was becoming too large and interest rates would rise as global investors sold their bonds as they questioned America’s ability to pay back its loans. With everybody on one side of the trade, it seemed to me that taking the other side was a no-brainer.

This turned out to be correct. So far this year, stocks have been a disappointment whereas Treasuries have performed very well. While I am less bullish on Treasuries now than I was in January, I still see a lot of potential in bonds and related exchange-traded funds.

However, I must emphasize that bonds should be held as a trade. Fundamentally, the bears are right.

  1. Supply is rising.
  2. The dollar is vulnerable to the downside, making Treasuries less attractive.
  3. Foreigners such as the Chinese are becoming less reluctant to hold Treasuries.
  4. Interest rates are historically low.

Furthermore, the reasons to hold Treasuries are trading reasons, not fundamental reasons.

  1. It seems that everybody is bearish of Treasuries, so we should be bullish of Treasuries.
  2. Bearish fundamental events fail to drive Treasuries lower. Examples include the fact that Russia may sell its holdings in the wake of the conflict between Russian and the U. S. over Crimea, and the fact that the Federal Reserve is buying fewer Treasuries as it has been tapering its quantitative easing program.
  3. Treasuries are technically strong. They are making higher highs and higher lows. They are also finding support at moving averages.

Therefore, investors who are interested in owning Treasuries should buy them as a trade. This means that they should limit their positions and use stop orders.

Those investors who are interested in owning Treasuries have several ETFs to choose from. The most common for Treasury speculation is the iShares Barclays 20+ Year Treasury ETF (NYSEARCA:TLT). This fund will give investors exposure to long-term Treasuries that mature in 20 to 30 years. It is highly liquid and it has a very low expense ratio of just 0.15 percent.

More aggressive investors should consider purchasing a leveraged ETF such as the Direxion Shares 20+ Year Treasury Bull 3X Shares (NYSEARCA:TMF). This fund will rise 3-times the amount that TLT does in a given day, and it will also fall by 3-times the amount TLT does if TLT has a down day. Note that this fund doesn’t simply give 3-times exposure to long-dated Treasuries.

Each day the fund “resets,” which means that its performance will diverge from TLT’s performance over time. For instance, suppose both funds start at $100 per share. TLT rises 10 percent to $110 per share, so TMF rises 30 percent to $130 per share. The next day, TLT falls 10 percent to $99 per share, so TMF falls 30 percent to $91 per share. TLT is down 1 percent overall but TMF is down 9 percent. However, this can work in your favor. Suppose on day two, TLT rises 10 percent instead of falling 10 percent. It rises to $121 per share. TMF rises 30 percent to $169. The gain on TMF is more than 3-times the gain you get on TLT.

Ultimately, if you don’t want to worry about this messy math, then don’t worry about leverage and stick to TLT. If you really want a Treasury fund that can potentially outperform TLT, consider the Pimco 25 Year 0 Coupon US Treasury ETF (NYSEARCA:ZROZ).

This fund holds 0-coupon bonds, which don’t pay a coupon but rather have a price that the U. S. government owes you when the bond matures. As the maturity date approaches, the bond approaches the maturity price. Early on in its life a 0-coupon bond can be rather volatile and offer leverage to the long-dated Treasury market. So far this year the fund is up 13 percent, beating virtually every asset.

Disclosure: Ben Kramer-Miller has no positions in the securities mentioned in this article.

More From Wall St. Cheat Sheet: