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Two Ways to Play Rising Yields and Bond Risk

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Risk in municipal debt, it seems, has never been higher. Yet the market has been pricing in ever rosier outlooks.

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Rising Treasury yields are now old news, but how much further they will rise is cause for great debate. On one hand, history suggests the yield on the 10-year should be significantly higher.

As S&P Capital IQ explains using the consumer price index (CPI) as a guide: "The historical relationship between CPI and the yield on the 10-year note tells a more ominous story. Since 1947 CPI recorded an average year over year increase of 4.39% while the 10-year averaged 6.16%, implying the yield on the 10-year traded at an average premium of 1.77% over CPI."

With a current CPI reading of 2.0%, history implies the 10-year should be trading closer to 3.77%. It currently resides at only 2.9%. But as the popular saying goes, "we can find a statistic for anything" as the analysis below shows.

Again from Capital IQ, this time using gross domestic product (GDP) to analyze interest rates: "History offers no solution to the interest rate debate, as it supports both rising and falling yields. The US economy grew by 6.39% annually since 1947. During that same period, the yield on the 10-year note averaged 6.16%." With the most current year's GDP of 2.93%, this suggests the 10 year should be closer to 2.7%, slightly lower than the 2.9% today."

And let's not forget about a third wrinkle in the yield uncertainty, the upcoming budget and deficit debates that are sure to have US Treasuries front and center on the world stage. Some estimates suggest the US will run out of money by October 1 if a new budget and debt limit is not in place. Two weeks later, defaults could follow.

How to Hedge Budget Debates and Rising Yields

In July, I wrote about the rising yield curve and implications of a steepening curve.Contrary to popular belief, a rising curve is not a bullish event, quite the opposite.

In that article I suggested hedging a rising yield curve by purchasing the iPath Treasury Steepener ETN (NYSEARCA:STPP). So far so good, as STPP has risen from around $39 to over $41 since then.

If Treasury yields continue higher, STPP will continue to benefit.

More aggressive traders might want to look into the iPath 10 Year Bear ETN (NYSEARCA:DTYS) which moves inversely to the 10-year bond price. If yields rise, then the 10-year price will fall and DTYS will appreciate. Another bearish bond exchange traded product is the ProShares UltraShort 20+ Year Treasury (NYSEARCA:TBT).

Have Muni Bonds Topped?

Muni bonds are wrongly getting lost in the debt debate shuffle as Treasuries remain the major focus. But municipal debt too should be front and center, especially with Detroit's recent fiasco and Puerto Rico's general obligation bond yields recently topping 10%.

Risk in municipal debt, it seems, has never been higher. Yet, the market has been pricing in ever rosier outlooks. That tide is finally starting to turn as municipalities feel the pressure of rising rates.

We have been expecting a top in muni bond prices since March, and I think that this is likely just the beginning.

As outlined in March of this year when I suggested the trend in muni bonds was over, municipal bond prices have since fallen over 10% with room for more downside.

A Way to Hedge Muni Risk

The chart below is one recently provided to our readers along with commentary surrounding a few trade setups that suggest there indeed may be plenty more pain for municipal bonds.



The top portion of the chart shows that since 2010, munis, as measured by the iShares National Municipal Bond Fund (NYSEARCA:MUB), have been underperforming Treasuries. This chart helps identify strength versus weakness and suggests a resumption of the weakness in muni bonds when compared to Treasuries. Based on the chart, muni bonds should now start to really underperform Treasuries.

The bottom portion of the chart (in green) also shows that recently Municipal bonds broke down from their four year long uptrend in place since 2009. That breakdown is a bearish sign that the muni uptrend is likely over with a near term target of $97, and longer term target much lower.

Couple that long-term trend breakdown with the top portion of the chart that shows munis are ready to resume their relative weakness to Treasuries and therein lies a high probability trade setup shorting munis and longing Treasuries.

There's another key element to big problems ahead for municipal bonds.

When it comes to the debt ceiling and fiscal deficit debates, the federal government has a printing press behind it. However, municipalities (as recently seen with the state of Illinois, Puerto Rico, numerous California cities, and Detroit) only have population growth and taxes to back their obligations. This is a primary reason why yields on Treasuries are always lower (and thus safer) than munis.

This also means that yields on munis can go significantly higher than their Treasury counterparts (Puerto Rico at 10% and Detroit defaulting are great examples).

A continued rise in yields would send MUB down significantly more than Treasury Bond ETFs such as TLT or the iShares Barclays 7-10 Year (NYSEARCA:IEF) and thus would make the short MUB, long Treasuries pairs trade profitable. Another way to protect from rising yields is purchasing the STPP.

Editor's note: This story by Chad Karnes, Chief Market Strategist, originally appeared on ETFguide.com.

To read more from ETFguide, see:

Excessive Bullishness Foreshadowed Gold's Meltdown

Is the New Look DJIA an Upgrade or Downgrade?

Are Auto Stocks Running Out of Gas?
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