The Coming Bond Collapse: Make a Killing – While Everyone Else Gets Killed

10 | By Shah Gilani

We’re hurtling toward the biggest bond bubble the world has ever seen.

It’s going to start leaking.

Then it’s going to pop.

Today I’m going to tell you what to look for – because I’m all over this.

I’m also going to share four handpicked recommendations that will soar when the bond bubble bursts.

With these four trades, you’ll do more than just survive this fixed-income-market freeze-up.

Lots more.

When the bond market craters – and it will – you’ll make a killing… while everyone else is getting killed.

Now I’m going to pull this all together for you …and show you how, why and when key global bond markets are going to tip over – and splatter their poison across the world’s stock markets…

The Lay of the Land

What I’m sharing today isn’t rocket science. This is a matter of understanding basic economics and what the study of market Disruptors is telling us about the future.

And this is a peek at the future you need to have: If you don’t understand what’s in store for bonds, you won’t know what’s going to happen to stocks.

With this prediction of what’s ahead, you’ll avoid the fate of everyone else as they lose what they have to the coming carnage.

And with the strategy I’ve created for you (keeping a promise I made in our last talk), you’ll actually cash in.

So let’s get started – with a very quick bond-market lesson.

The bond market – meaning the market for all bonds all around the world – dwarfs the size of all the stock markets in the world combined. If you look at the averages over the past quarter century, the bond market has been 79% larger than the stock market (and in 2012, it was 104% larger).

For the most part – and most people who aren’t economists or capital-markets specialists don’t know this – stocks trade off bonds. That’s because (as we’ve shown you in past reports here) when interest rates rise and bond prices fall, bonds become more competitive with stocks. Generally speaking, an investor would rather own a promissory note that pays a good interest rate over more speculative stocks.

Over the last eight years, because central banks have manipulated interest rates down to artificially low levels, bond prices have been on the march. Higher bond prices and low interest rates have prompted investors to move out of bonds and into stocks.

In fact, bond prices have risen so high that trillions of dollars’ worth of bonds actually have negative yields, or interest rates.

According to the BlackRock Investment Institute, there are $5.3 trillion worth of bonds today with a negative yield; 60% of those bonds, or $3.18 trillion worth, are European bonds.

Negative interest rates are insane.

That means the investors who hold these bonds don’t get paid interest; they have to pay interest – for instance, paying the government for the right to loan it money.

Bond Market Math

Europe is Ground Zero for the bond bubble because most of those negative-yielding bonds are bonds issued by European Economic and Monetary Union (EMU) nations.

Yields on outstanding bonds became negative because buyers of those bonds kept paying higher and higher prices to own them. And as we’ve already seen here, as prices for bonds rise, their yields fall.

Why have banks, institutions and speculators been bidding up the prices of bonds issued by European governments to the point where these investors are paying such a high price that the yields they are getting are actually negative? Because, back in January, the European Central Bank (ECB) announced it was going to play the quantitative-easing (QE) game and buy more than a trillion dollars’ worth of bonds issued by EMU members.

In a classic “front running” move, speculators – knowing the ECB was going to start buying bonds – paid higher prices for trillions of dollars’ worth of bonds, which drove yields into negative territory. It wasn’t that investors were willing to accept negative yields; they believed the ECB would eventually buy them at those inflated prices. In March, the ECB started buying about $60 billion worth of those bonds a month.

On paper, that’s a nice trade.

But there’s a problem.

To see it, just do the math.

If the ECB buys $60 billion of bonds a month from the banks and speculators who bid them up and have nice paper profits on their inventory, we’re talking about central-bank purchases of about $720 billion a year.

Say the ECB ends up buying $1 trillion worth of bonds at the current “bubble prices” it is paying.

That would still leave about $2.18 trillion worth of negative-yielding bonds in the hands of the banks and speculators who bid them up and are now sitting on paper profits.

It’s called a “paper profit” because these investors still own the bonds, meaning the gains they have are “on paper” – are accounting gains.

Until the traders actually sell the bonds and “realize” (lock in) them in, they are profits on paper only.

So as the ECB drops $60 billion a month on bonds whose prices are grossly inflated, all the holders of all the rest of the trillions of dollars’ worth of bonds have to sit on their inventories of bonds, hoping and praying nothing goes wrong.

And there’s a lot that can go wrong.

First, almost all of these bonds were bought with borrowed money, meaning all the holders are leveraged to a huge degree.

Then there are the central banks.

The ECB, like all monetary authorities – the U.S. Federal Reserve included – is a paper tiger.

It’s not a “real” bank with real capital, buying bonds with its money. The ECB has no significant capital; in fact, it really doesn’t have any capital.

The capital that central banks supposedly have is the capital they need – if they need it – to be supplied by the taxing power of the governments that authorize central banks to play their games. Or they simply print money and say, “Look, we have capital.”

With the ECB, it’s the EMU members – and, theoretically, all European Union (EU) members – who are supposed to provide the backing. Germany, for one, isn’t always keen on central-bank money printing, given its visceral fear that such policies will ignite inflation (something the country has a lot of history with).

Voters in Germany and other parts of the EU can say “no” to the ECB – undermining its credibility by doing so.

The United Kingdom is going to hold a referendum on whether its citizens want to stay in the EU.

So there are seeds of discontent – a lot having to do with the ECB spending wildly to prop up some grossly over-indebted and underperforming member nations.

Then there’s the specter of inflation. Sure, there’s none right now. But that can change.

Any big uptick in inflation would send a chill throughout the entire bond market, as the prospect of higher future rates would devastate current bond prices.

There are also concerns about interest rates themselves.

And those concerns are real.

The Going Rate(s)

To start with, at some point, the Fed is going to raise domestic rates.

And that move will have observable impacts.

The world is connected both economically and via the global capital markets. When rates rise in the United States, U.S. investment capital currently planted overseas will join with foreign investment flows to stream back to American shores to take advantage of higher interest rates. The “capital flight” out of countries that need that money will wreak havoc on their markets and economies. To steam that outflow of money seeking higher rates of return, those countries will raise their own interest rates.

How’s that going to work out for all those speculators holding high-priced, negative-yielding bonds?

Not well.

Bond prices will fall, and leveraged players will panic and dump bonds, further tanking prices.

Nothing goes up forever. As I predicted at the outset of today’s talk, we’re now looking at the biggest bond bubble the world has ever seen.

The only thing that’s not assured is the timing of the explosion.

But now you know how it’s going to end. And you know what to look for.

I’m not the only one who’s predicting a bond-market debacle.

Back in late April, Bill Gross, who cofounded Pacific Investment Management Co. (PIMCO) and is now a bond-portfolio manager with Janus Capital Group, tweeted that “German 10-year bunds [are the] short of a lifetime. Better than the pound in 1993. Only question is the timing.”

Doubleline Capital founder Jeff Gundlach, the other bond king, agrees and is betting on an EU bond implosion.

Billionaire Paul Elliott Singer, founder of the massive hedge fund Elliott Management Corp., calls the opportunity to make money on the European bond market collapse “The Bigger Short.”

“The Big Short” refers to the billions made by a handful of hedge-fund managers who shorted wildly when the subprime bubble collapsed into the credit crisis. The Bigger Short is Singer saying this implosion – and the shorting opportunity is represents – represents an even bigger investment play than what we saw in 2008.

A Profitable “Promise”

Over the last several sessions, as we’ve talked about bonds, the art of “shorting” and the recent bond-market “Flash Crash,” I promised I’d round out this series of talks with strategic recommendations that would protect you from looming bond-market debacle – and let you profit from it.

I keep my promises. And today I’m delivering.

When the European bond bubble breaks, you want to be short European bonds, short European stocks and short the euro against the U.S. dollar. You’ll also want to buy U.S. Treasuries, as their price will skyrocket in a “flight to quality” trade.

To short European bonds, I like buying “puts” on the iShares PLC Markit iBoxx Euro High Yield Bond ETF (LON: IHYG). There aren’t good, liquid exchange-traded funds (ETFs) that give us the direct exposure we want to short European government bonds. And shorting IHYG is a problem because it has a 4.29% dividend yield. That’s why I like buying long-term puts on IHYG here, but especially if its price is above $110.

To profit from falling European stocks, I recommend shorting the iShares MSCI EMU ETF (NYSE: EZU), which holds stocks in all the EMU countries.

When the collapse happens, the EMU’s currency – the euro – will collapse, too. I recommend buying the ProShares UltraShort Euro (NYSE: EUO). This is a “leveraged” ETF, meaning it moves two times as fast as the euro trades against the U.S. dollar. Buy it when interest rates start ticking up in Europe.

Lastly, in a panic based on a European bond-market implosion, money that comes out of European bonds and exits panicked markets will rush into the safe haven of U.S. Treasuries. I expect Treasuries to soar on a European implosion. A great way to play rising Treasury prices is by buying the iShares 20+ Year Treasury Bond ETF (NYSE: TLT).

The timing on this Disruptor-triggered trade will be tricky. But the hefty payoff will make it worth the wait.

We’ll watch together as it unfolds.

And we’ll talk about it here as it does…

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10 Responses to The Coming Bond Collapse: Make a Killing – While Everyone Else Gets Killed

  1. Frank says:

    I do like most investors do and carry on like there is no tomorrow. It is so scary that I don’t want to know about it. Besides that I have no money anyway, so I don’t have to be scared and worried. A good way to be!

  2. Sherri says:

    I agree with Lynn, is there a ticker on the NYSE for IHYG? I don’t have access to the London Stock Exchange, and if the other comment is correct and there is a bubble in the US Treasuries is there a trade for that?

  3. Bill says:

    iShares PLC Markit iBoxx Euro High Yield Bond ETF (LON: IHYG) cannot be traded through Schwab International desk. I enjoyed reading your article and found your explanation to be clear and straight forward. We (I) will need to select another way to short The European Bond Market. The Schwab representative told me that options for IHYG are not available to even investors using the London exchange. Apparently if an ETF is not incorporated in the US, Schwab does not offer trades in that ETF. Schwab does offer trading through its International trading desk but ETFs must be incorporated in the US for them to handle the trade.

    Can you suggest another ETF that either pays no dividend or has options available with some decent volume in the option reades?


  4. Dean says:

    It seems that the same analysis would apply to the Japanese bond market. Would not the Fed’s raising interest rates cause a flight from Japanese bonds into U.S. bonds? If so, that would make the price of Japanese bonds fall, causing panic selling, causing Japanese bonds to fall. Are there any ways to short the Japanese bond market?

    What effect will all this have the on the U.S. bond market? If the Fed increases interest rates, that will cause U.S. bond prices to fall, creating a shorting opportunity. If the Fed increasing interest causes a flight from foreign bonds into U.S. bonds however, will that not frustrate the Fed’s attempt to increase interest rates, and cause those who shorted the U.S. bond market to lose their shirts? Would the proper course be to go long in the U.S. bond market?

  5. Patricia says:

    HI, As a newcomer, I still don’t understand when we’re supposed to get out. I had 25% trailing stops, as I’ve been told; but some tell me some of the stocks are long term. If we go bust, WHAT IS LONG TERM. I don’t understand and no one seems to want to answer; but THEY LOVE IT when I subscribe to their publications and “feather their nest”. Help, Someone!

  6. A L says:

    As a new subscriber, I am overwhelmed with the info provided ! There seems to be to much writing and explanation AND way too much adv for additional articles to subscribe. Hard to know where to turn for investing advice. Are more simple outlines out there to adhere to? Len

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