Short Treasuries TBT
December 24, 2008 - 1:35am EST by
neo628
2008 2009
Price: 36.62 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 660 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV (in $M): 0 TEV/EBIT

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Description

I am going to recommend that you short intermediate to long-term US treasuries because it is one of the last asset class bubbles going today and unlike the other bubbles, it has inflated substantially to all time highs while all other asset classes have suffered. 
 
Due to technical factors, investors have sold (dumped) almost all risky assets and have rushed to buy US treasuries.  As a result of this flight away from all assets perceived as risky, treasuries have become incredibly overvalued.  The short end of the curve is telling as T-bills (even prior to the recent move by the Fed to lower the target fed funds rate to nearly 0% were already trading at or close to 0% yield.  The yield even went negative briefly with bids on certain short-term treasuries actually higher than the interest + par to be received till maturity!

The current curve is as follows:

1 Year        0.39%
2 year        0.87%
5 year        1.47%
10 year       2.14%
30 year       2.62%

Although near term expectations are for the economy to enter a bout of deflation, the government is doing everything in its power now to reflate the economy by "throwing money out of helicopters" to quote an old Bernanke speech.  In this battle, since the govt. and the Fed can and will conspire to print money, the forces of inflation have to win.  It has not worked immediately because although the quantity of money in circulation has exploded already, the velocity of money has dropped recently as shell shocked consumers and financial institutions have been shocked into reining in their activity thereby masking the increase in the quantity of money for now.  However, it is extremely likely that the coordinated actions in the US and elsewhere will have their intended effect and that the economy will be re-inflated.  In addition, it is hard to sustain gloom and doom forever.  People can defer purchases and activity for a while, but some of the activity eventually has to normalize the velocity of money at least somewhat higher.  As this becomes evident, the above yields will be too low and investors will sell off their positions, driving prices down very rapidly.

Although you can simply short long-term treasuries directly, or perhaps directly use financial derivatives with a good counterparty and security, another (perhaps logistically easier) way to implement the trade is to consider purchasing (going long) TBT - the Proshares Ultrashort Lehman 20+ Year Treasury.  This ETF utilizes derivatives and financial instruments that are indended to deliver twice (200%) of the inverse of the Lehman Brothers 20+ US Treasury Index.  Because of the recent flight to safety, TBT has fallen approximately 50% since August 2008, from around $70 per share to a current price of around $35 per share.

Just so you know what you are shorting, the Lehman Brothers 20+ Uear Treasury Index includes ALL publicly issued, U.S. Treasury securities that have a remaining maturity greater than 20 years, are non-convertible, are denominated in U.S. dollars, are rated investment grade (at least Baa3 by Moody’s Investors Service or BBB- by S&P), are fixed rate, and have more than $250 million par outstanding.  The Index is weighted by the relative market value of all securities meeting the Index criteria. Excluded from the Index are certain special issues, such as flower bonds, targeted investor notes (TINs), U.S. Treasury inflation protected securities (TIPs), state and local government series bonds (SLGs), and coupon issues that have been stripped from assets already included.  So basically this is the right one to short because is is very broadly diversified and liquidy index among long-duration treasuries.

Currently, TBT is trading just a hair above its 52-week low of $35.51 (Price on 12/23/2008 of $36.62).  Today the volume traded was 3.7 million shares (versus average 3 month volume of 1.338 million) so well above average volume indicating high interest in this trade.  At 3 million per day, the volume is around $100 million per day which should be more than enough for most VIC members interested in this short (through the EFT). 

Of course, is you long this ETF, you have a leveraged position in the short which increases your risk somewhat.  Since the manager is utilizing a combination of leverage and/or derivatives, there is some counter party risk which is difficult to quantify.  Though I looked for it, I did not see a way to find the specific counterparties, collaterial, securities underlying this ETF.  This is not ideal, though given the liquidity of the treasury market and this index on the long-side, it is not difficult to imagine that there would be a fairly long-list of banks and others that would take the other side of this trade.
 
The risk essentially is along the lines of the following: Treasuries could implode, but through either botched implemention of the trade by the investment manager (Proshares) and/or due to a counter party default, the ETF might not rise 200% of the movement in treasuries - and in the worst case it could even fall.  This is probably not a high probability at this point since the Fed has more or less indicated that most of the surviving investment banks are "too big to fail" and will be bailed out going forward (which may not even be necessary).  Also, TBT trades in the market so you can sell for your gain as long as the manager does not announce a failed counterparty right away.

Looking at the extremes in the treasury market at present, this is a high upside and low downside trade.  If deflation fear continue for a while longer, there may be a bit more downside on these shares, but probably not much more.  It is hard to image long-term treasuries going much below 2% on the 30 year.  Since the dollar is falling and Fed is printing money as fast at it can, this is quite bearish for long-term treasuries currently trading far above PAR.  There are many ways to win and relatively few ways to lose.  I would think that this ETF could quickly move up around 50 to 100% in the next 6 to 18 months from now for a very attractive IRR from current levels.

Catalyst

* Fear subsides
* Inflation increases
* Foreign investors start selling Treasury positions
* Markets start to recover inducing investors to pull money out of treasuries and into somewhat riskier assets
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