ITBF: My Top Pick Among Inverse Bond ETFs To Hedge Against Rate Hikes

To bring inflation under control, the Federal Reserve announced that it will begin increasing the target range for the federal funds rate at its Federal Open Market Committee, FOMC, meeting in two weeks. The federal funds rate is the FOMC’s main policy rate and sets the interest rate at which banks lend their excess reserves held at the Fed to each other overnight. The Fed uses various monetary policy tools at its disposal to move this rate: open market operations, the interest rate the Fed pays on bank’s reserve balances, and the interest rate the Fed charges on overnight reverse repurchases. Market expectations were originally for the Fed to increase its upper target range for the fed funds rate by 0.25% to 0.50% from its current level of 0.25% and then to continue to raise its target throughout the year during the six subsequent FOMC meetings. However, given Federal Reserve Chairman Jerome Powell’s recent statement that he would propose a 0.25% rate increase because of the war in Ukraine, expectations have probably backed off from 0.50%.

The increase in the fed funds rate will cause other interest rates to rise, particularly for short-maturity Treasury bills and notes. When rates rise, bond prices fall—not a good thing for bond portfolios. The longer the maturity of bonds in a portfolio, the more negative the effect rising rates will have on the portfolio. For this reason, in a rising rate environment, you should not hold bonds; but if you do, you want to hold short-maturity bonds—meaning bonds with low durations—because this will minimize the negative impact of rising interest rates.

The duration calculation takes into account a bond’s coupon payments along with its maturity and serves as a measure of a bond price’s sensitivity to changes in bond yields. A high-duration bond or bond portfolio has a duration greater than 10 years, and a low-duration bond is below 3 years. The higher the duration of a bond or a bond portfolio, the more sensitive it is to rate changes. When interest rates rise, the prices of these high-duration bonds fall considerably. Compare this to short-duration bonds, the prices of which will also fall when rates rise, but by a smaller amount. Calculating duration is somewhat complicated, but duration calculators can be found online, such as here.

In a rising interest rate world, ideally you would not want to hold bonds in your portfolio, but many investors still do. Given the Fed’s expected actions this year, if you are going to hold bonds, make sure they are, at least, short-duration bonds. There is, however, a better alternative: investing in bond portfolios in which the bonds are shorted. These portfolios will have negative duration. To explain, with a long bond position, when rates rise, bond prices will fall; however, with a short bond position, when rates rise, the value of the shorted bond will also rise. In my view, this is the perfect situation for today’s circumstances, but not so good for most years, so be careful with what I am proposing.

Eight Inverse Bond ETFs You Can Invest In

There are only eight ETFs available today that short bonds, called inverse bond funds. Seven of the ETFs are U.S. Treasury funds, and one is a high-yield debt fund. Because inverse bond funds are shorting bonds, they use leverage. Leverage is a multiple, determining how many times the fund is shorting bonds relative to the initial capital it holds. Five of the inverse bond ETFs include leverage multiples of two (-2x) or three times (-3x) (the minus sign indicates they are short). The more leverage the fund has, the riskier it is, so be careful.

Inverse bond ETFs do not actually short bonds; rather, fund managers achieve their short objectives predominantly via swap agreements and a little bit of short selling of interest rate futures contracts. It is cheaper to short bonds in this manner rather than directly shorting them.

All but one of the available inverse bond ETFs are based on shorting two Intercontinental Exchange, ICE, bond indexes. The intent behind the ICE Bond Indexes is to measure what is happening in the U.S. Treasury market. They designed the ICE U.S. Treasury 7-10 Year Bond Index to measure the performance of U.S. Treasury fixed-rate securities with a minimum remaining term of seven years to less than or equal to 10 years. They designed the ICE U.S. Treasury 20+ Year Bond Index to measure the performance of U.S. Treasury fixed-rate securities with a remaining maturity greater than 20 years.

In Table I below, I list the inverse bond ETFs that are available to invest in, along with their leverage, assets under management, AUM, expense ratios, average monthly trading volumes, and risks. In Table II, I show their historical returns year-to-date (YTD) and at six months and over one, three, and five years. To help put the inverse bond ETFs into perspective I include in the tables two iShares long bond ETFs (highlighted in orange/yellow), one based on the ICE 7-10 Year Index and the other the 20+ Year Index. At the top of each table, I present the 7-10 year maturity ETFs, then the group of 20+ maturity ETFs, and at the bottom the inverse high-yield bond ETF.

The Seeking Alpha links to information on the above ETFs, following the order in the table, are: (IEF), (TBX), (PST), (TYO), (TLT), (TBF), (TBT), (TTT), (TMV), (SJB).

Six observations from Table I.

• All the inverse bond ETFs have similar expense ratios, 0.9% to 1.07%, but the iShares long bond ETFs’ expense ratios are much lower at 0.15%.
• The more leverage an ETF has, the higher its risk, as measured by its standard deviation.
• The 20+ maturity ETFs have higher risk than the 7-10 year maturity ETFs of the same leverage.
• The Direxion Daily 7-10 Year Treasury Bear 3x ETF’s AUM is the smallest of the ETFs, at only $33 million AUM and correspondingly has the lowest average trading volume at only 1.47 million shares per month.
• The ProShares UltraShort 20+ Year Treasury ETF has the largest AUM at $1.41 billion, as well as the highest average trading volume at 114.85 million shares per month.
• The high yield ETF is slightly riskier than the ProShares Short 7-10 Year Treasury ETF and has relatively low AUM and trading volume.

Eight observations from Table II.

• The Direxion Daily 20+ Year Treasury Bear 3x ETF and ProShares UltraPro Short 20+ Year Treasury ETF both have the highest YTD returns at around 15% and both are -3x leveraged.
• The ProShares Short 7-10 Year Treasury ETF has the lowest YTD return at 2.32% and is -1x leveraged.
• All the 7-10 year maturity ETFs have positive returns at the one-year horizon, but none of the 20+ maturity ETFs do.
• All the inverse ETFs suffered losses through the three- and five-year horizons. The more leverage the ETF had, the larger its losses. The longer bond maturity an ETF has, the larger its losses.
• Both iShares long bond ETFs have positive returns at the three- and five-year horizons, with the 20+ maturity ETFs having the biggest gain of around 33% at the five-year horizon.
• The Direxion Daily 20+ Year Treasury Bear 3X ETF had the largest loss at -70.97% for the five-year horizon.
• Notice that the returns most often do not double or triple as you go from -1x to -2x to -3x.
• The returns on the inverse high-yield ETF have a distinct pattern compared to other ETFs based on the ICE Indexes.

In the current environment, these inverse ETFs are performing better than any long bond ETFs, which all have negative returns YTD. The average return YTD on ultrashort government bond ETFs is -0.05%, for short government bond ETFs -1.1%, for intermediate Treasury ETFs -2.3%, and for long Treasury ETFs -4.78%. In comparison, U.S. Treasury Inflation Protected Securities, TIPS, ETFs have an average YTD return of 0.07%. I also examined the four zero-duration or hedged bond ETFs that are available. These ETFs are both long and short bonds and have zero leverage (0x). All these ETFs performed as poorly as the long only ETFs just mentioned.

The data in the tables indicate there is a strong trade-off between risk and return; if you are willing to hold more risk, you can potentially achieve high returns when rates are rising. Of course, on the downside when rates are falling, that risk will expose you to large negative returns, so be very careful.

Also keep in mind that these inverse funds are not cheap. The average expense ratio in 2021 for all index bond ETFs, which includes inverse ETFs, was 0.13%, compared with an average value-weighted expense ratio of 0.93% for only these inverse ETFs. Reflecting this, Seeking Alpha gives all these ETFs a D or an F for their high expense ratios. Note that an expense ratio covers the costs of managing the ETF, not the costs of shorting the bonds. The asset management company takes the shorting costs directly out of the ETFs’ returns.

Choosing Between ETFs

If market expectations are correct, movements in interest rates will lead any Fed actions. This is what we have seen over the last six months. For example, yields on one-year Treasury bills have gone from 0.65% last September to a peak of 1.125% in February, before falling back to around 1.032% today.

Clearly, Treasury markets have already incorporated an expected change in the fed funds rate in March of at least 0.25%; therefore, it is possible that interest rates will not change in response to the March FOMC meeting. This is important because inverse funds are shorting bonds, and there is always a cost of doing so; in periods when bond yields do not vary, they will have negative returns to cover these costs. Therefore, if market rates do not rise in March, because the FOMC’s decision to raise the fed fund rates has already been anticipated, these inverse bond ETFs’ returns could be zero or negative in the near term.

Nevertheless, the FOMC has six more meetings scheduled in the remainder of the year. Market expectations have not settled on the outcomes of those meetings and what future changes in the fed funds rates might be, beyond expecting the Fed to continue to increase the rate. Therefore, the very near-term returns for these ETFs are unknown; however, I expect them to perform well over the course of the year.

One note of caution: investing in inverse bond ETFs is not a long-term strategy. This is because bond yields often do not vary much across time and, therefore, there is no advantage to holding inverse bond funds. In fact, the opposite holds. In my view, you should consider investing in any of these ETFs for no more than one year. Determining the exact time horizon is for the most part a function of what happens to inflation.

Whether you invest in -2x or -3x portfolios is a function of your appetite for risk, as is whether you invest in the 7-10 year or 20+ year portfolio. Personally, I am not a fan of 2x and 3x funds, long or short. For me, the risk is too high. Moreover, because of the cost of borrowing, you almost never earn 2x or 3x returns, but you do face 2x or 3x risk levels. For myself, I consider the ProShares Short 7-10 Year Treasury and ProShares Short 20+ Year Treasury ETFs preferable because they are not too leveraged. The remaining issue for me is the 7-10 Year ETF’s AUM and trading volume are too low; therefore, I am going to go with the ProShares 20+ Year ETF.