In the offices here at LearnBonds there is an ongoing debate. Once a day, I make a comment about how interest rates are going rise, to which I get the following response: “You were saying the same thing a year ago.”
The current yield on the 10-year is 1.0% (a 33% move) lower, even after the run-up in mid- March. You would have lost a lot of money investing based on my belief rates would go higher, and it is possible for rates to go lower still.
This being said there are a lot of people out there who agree with me, and a lot of talk in the trading community about how to profit when interest rates rise. These conversations inevitably turn to the bond market, and soon after to “inverse” bond ETFs which are designed to rise in value when interest rates rise (and the price of the bond falls).
While we are certainly not recommending that long term investors speculate on changes in interest rates, those who are going to speculate on the bond market with inverse ETFs should keep the following in mind:
Duration measures the sensitivity of a bond’s price to a move in interest rates. If a bond has a duration of 5 and interest rates move up by 1%, the bond’s value will fall by 5%. The farther a bond’s maturity date is in the future, the higher its duration. By buying an ETF with a very high duration, you will not need leverage to turn a modest interest rate move into a big profit or loss. You can learn more about bond duration here.
While corporate bonds with high credit ratings generally follow changes in treasury yields, moves are not always a one to one ratio. Overall economic conditions have a major impact on the spread between Treasuries and corporate bonds. If you think Treasury yields will rise, its best to stick with a Treasury ETF.
If you buy a 3x leverage ETF (and there are several inverse bond ETFs that offer this), you would expect the ETFs performance to be 3 times the performance of the unleveraged ETF. The problem with this assumption is that it only holds true for 1 trading day. If you are trying to capture a medium or longer term move in rates, the performance of the leveraged ETF can be drastically different than the 3X’s performance one would expect. This is true not only for Bond Market ETFs, but for leveraged ETFs in general.
For these reasons, I am suggesting that those who want short exposure to the bond market use only non-leveraged, high duration, inverse ETFs as a way of playing an increase in Yields. Unless you have a view on a specific sector of the bond market, then I also suggest those who want a pure interest rate play stick to inverse treasury bond ETFs.
This ETF provides the inverse performance of the well-known and popular TLT ETF. The duration of the ETF is 17.4 years, which means that a 1.0% move in interest rates should produce a 17% change in the value of the the ETF. The net expense ratio of the ETF is 0.95% however, which is relatively high.
This ETF tracks the NYSE 20 Year Plus Treasury Bond index and has a slightly lower duration of 16.25 years. On the plus side, the next expenses are a bit lower at 0.65%.