Perhaps the biggest investing “story” of the year is whether or not the Federal Reserve is going to raise interest rates. The Fed has kept interest rates at zero since the beginning of the Great Recession and credit crisis in order to stimulate growth in the economy. With things slowly grinding forward and some progress being made across jobs, GDP growth, and overall economic well-being, the Fed is finally getting ready to raise those rates.
And that’s a big problem for investors, especially those who have plowed big-time money into bond ETFs like the iShares 20+ Year Treasury Bond (TLT ) and Vanguard Total Bond Market ETF (BND ) searching for yield. They’ll lose some serious coin when Janet Yellen and Crew finally begin ramping up benchmark rates.
But there is a way to profit from the Fed’s interest rate increases when it comes to bonds. Namely, by betting against them. Inverse bond ETFs could be one of the biggest plays for the rest of the year.
A Pesky Thing Called Duration
The problem for bonds when it comes to rising rates is that the two have an inverse relationship. This essentially means that as interest rates rise, bond prices will fall. This is because investors can now buy a similar bond at a higher interest rate. That relationship is slightly less significant if you own individual bonds and plan on holding them until they mature, since you’ll get the face value back. Although, if you bought the bond at a premium, you will lose that premium amount above the face value. On the other hand, for bond ETFs, the rise in interest rates can be a big problem. That’s because they are constantly rolling over their portfolios of bonds to meet their mandates. As bond prices fall, so will the prices for the underlying ETFs – and that fall in prices will stick.
And for those investors looking at long-dated bond ETFs for yield, that fall is going to be felt even harder.
This is due to something called duration. The easy way to think about duration is that it’s a way to measure a bond’s price sensitivity to interest rate movements. A lot of metrics go into calculating it: present value, yield to maturity, coupon, face value, term, frequency of coupon payments, call features, and other features – but it all comes down to how a bond is going react to interest rate changes.
The longer the duration, the worse the drop. For example, if interest rates were to rise by 1%, a bond ETF, like the $10 billion and uber-popular iShares 7-10 Year Treasury Bond ETF (IEF ) and its average duration of around 8 years, would see its price fall by around 8% or so. Meanwhile, a similar investment with a one-year duration might only decline by 1%.
Time to Go Short
Given the inverse relationship and the fact that bond ETFs will fall on Fed rate increases, investors looking to cash in or potentially hedge their portfolio might want to take a gander at inverse bond ETFs. By using various swaps and futures contracts, inverse bond ETFs will actually go up when bond prices go down. That allows investors to profit from the eventual rise in interest rates. Taking into consideration just how close the Fed is to raising rates, the time to add a dash of inverse bond ETFs to your portfolio could be now.
However, keep in mind, this isn’t a risk-free trade. Analysts have been calling for a rise in interest rates for years now, and inverse bond ETF investors have suffered that whole time. Secondly, they are expensive to own in terms of fees. Finally, many add a dash of leverage to their holdings. That amplifies any losses over time.
Given that bonds with longer maturity and durations are going to feel the most pain, the Direxion Daily 20+ Year Treasury Bear 3X ETF (TMV ) could be a good first stopping point for investors. The ETF bets on 3x the daily inverse exposure to long-term Treasury bonds. Ultimately, TMV allows a leveraged short position in the previously mentioned TLT ETF. Expenses for TMV run 0.95% or $95 per $10,000 invested. For investors not looking to use any sort of leverage, the ProShares Short 20+ Year Treasury (TBF ) offers a 1x short position against the TLT and the Barclays U.S. 20+ Year Treasury Bond Index.
While the effect won’t be as dramatic, intermediate bonds, or the kind tracked by the earlier referred to IEF, will also see their prices fall as rates rise. The ProShares UltraShort 7-10 Year Treasury (PST ) provides 2x the daily inverse exposure to the Barclays U.S. 7-10 Year Treasury Bond Index. PST also charges 0.95% in expenses.
Finally, it’s not just Treasury bonds that will feel the pinch. Corporate bonds with long maturities will suffer in the face of rising interest rates. The ProShares Short High Yield (SJB ) allows investors to short the riskiest sector of the corporate bond market, which also has increased default risks when it comes to rising rates.
The Bottom Line
With the Fed now seriously considering raising interest rates, investors in bond ETFs, especially longer-dated bond ETFs, could be facing a world of hurt. By going short via inverse bond ETFs, investors can potentially profit from the rate increase or hedge away some of their bond portfolio risk.
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