April 4, 2013
Stopped out of the SBND trade at 7.50. I thought that this bond bear trade was probably early, and it was. With yesterday’s sudden stock market drop, money is moving back into bonds, and higher bond prices means a lower price for SBND, which is a 3x leveraged short bond ETF.
There is also one other factor at play with short ETFs like this one. Because many ETFs are based off of commodity futures contracts, they are affected by any contango or backwardization in the futures markets.
Before I explain what contango and backwardization are, I’ll first explain what the futures markets are. The futures markets are where major producers and consumers of commodities buy and sell the raw goods or commodities needed in their businesses. It is called the futures market because there are price contracts at various months going out in the future.
Businesses always need to watch, control, and ultimately lock in the price of the raw materials used in their products. They use the futures markets to do this. For example, a cereal maker like General Mills would use futures contracts to lock in a price for the wheat that they need for making cereals. They know they need 1 million bushels of wheat in 6 months, so they lock in a price today by buying futures contracts equal to 1 million bushels. Otherwise, if the price of wheat skyrockets by the time they need the wheat, it may be too expensive to produce and sell their cereals at a profit.
Likewise, the farmer growing wheat looks to lock in a price today at which he sells his wheat in 6 months. Then he is not at risk of prices being low when he goes to sell it. He knows when he plants the wheat that he will get a fixed price for it when it is ready for harvest.
The futures markets not only include commodities like cattle, hogs, wheat, sugar, and coffee, but precious metals, stock indexes, and bond indexes.
Now, prices of a futures commodity contracts typically move higher the farther out in the future the contracts go. This premium reflects the carry and storage costs for the commodity over time. This is called contango. While this is normal in futures contracts, it has a negative effect on ETFs based on the commodities. The reason is that the ETF must continually sell contracts that are expiring and purchase new ones that extend out into the future The ETF loses money each time it purchases higher priced, later dated contract; in essence, the ETF is selling low and buying high. Investing in these ETFs for long periods can be frustrating, as you will notice that they may be losing money even if the prices of the underlying commodity are flat or even moving in the direction you want. For short-term trades (futures contacts generally roll over to the next contract every few months), most commodity ETFs track the underlying commodity price well. It’s the longer-term holding of ETFs that can be frustrating for investors.
Backwardization occurs when the prices going out into the future are lower than the current price. This would be ideal for ETFs, as they would be selling expiring contracts high, and buying the farther out ones for a lower price. Unfortunately, this is much more rare.
SBND, being based off of government bond futures contracts, actually sold off and stopped me out without a major move up in the bond’s price. Remember, this is an inverse bond fund betting that bond prices will fall. Over the last couple of months I noticed that bond prices went up a little, but not a lot. I suspect the move down in SBND is partly attributed to the contango element of the bond future’s market.
The problem for investors is that there are few ways to bet against higher bond prices except using short ETFs or shorting the actual futures markets. The futures markets are for the big boys with large amounts of capital, so for most investors we are stuck with the ETFs.
At this point I will stand aside and watch for another entry point. At some point this will be the trade of a lifetime!
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