Are US bonds worth the paper they are written on?

Ian de Lange of Seed Investments writes that 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.”

How would this work?

Normally if a government or large corporate wishes to borrow money, it issues bonds at various interest rates and with various redemption (exit or sell) 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 some many 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.  

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 below indicates the extent of the growing problem.

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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, then the correct trade will be to sell bonds short at current yields and buy then 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 in government bonds. We saw this in 2008 and again over the last 2 days where global markets have 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 a safe investment does not make it easy for investors. It complicates matters where some are now calling that the way to make money is to short these traditionally “safe haven” investments. This is truly not a simple investing environment.