Using Inverse ETFs to Hedge Interest Rate Risk

June 12th at 5:11pm by Tom Lydon

With interest rates rising, more aggressive traders are using short or inverse exchange traded funds to capitalize on weakening Treasuries and fixed-income assets, but the instruments do not come without risks.

Timothy Strauts, ETF analyst at Morningstar, points out that funds like the ProShares UltraShort 20+ Year Treasury (NYSEArca: TBT) offers investors the opportunity to generate an inverse leveraged daily return – if the Barclays 20+ year U.S. Treasury Index dips 5%, the fund tries to reflect a 10% gain for that day.

The iShares Barclays 20 Year Treasury Bond Fund (NYSEArca: TLT) has declined 3.8% over the past month, whereas TBT has gained 7.4%.

Source: Yahoo! Finance

Strauts, though, warns that these funds will probably not deliver the exact inverse or leveraged return over holding periods longer than a single day. These types of investments are better suited for sophisticated investors who know the risks involved with these types of short-term hedging tools.

“A combination of poor timing and volatile, nontrending market moves will likely mean that those using these funds will lose money while they wait for their thesis to pan out,” Strauts said. “Even in the unlikely event of perfect timing, those using these funds will probably not experience anything close to negative 2 times the return of the underlying index unless the index trends consistently in the same direction. Volatile markets are a worst-case scenario for leveraged products.”

Investors would have to rebalance their allocations on a frequent basis to mitigate the negative effects of daily compounding.

Alternatively, Strauts suggests investors can also use short-duration bond ETFs to diminish interest rate risk in a fixed-income portfolio. Duration is the measure of a bond’s sensitivity to interest rates. Bonds with shorter durations are less sensitive to interest rates. The analysts points out three ETF options:

  • Vanguard Short-Term Corporate Bond Index Fund (NYSEArca: VCSH). VCSH holds corporate bonds with maturities between 1 and 5 years and an effective duration of 2.9 years. the fund has a 0.12% expense ratio.
  • PowerShares Senior Loan Portfolio (NYSEArca: BKLN). Bank loans come with variable rates – the interest rates on bank loans are adjusted every 30 to 90 days. The fund has a 3.8% 30-day SEC yield. [Bank Loan, Floating Rate ETFs for Rising Interest Rates]
  • PIMCO -5 Year High Yield Corporate Bond (NYSEArca: HYS). HYS holds high yield corporate bonds with 0 to 5 year maturities, and the fund has an effective duration of 2 years. The ETF has a 3% 30-day SEC yield. [High-Yield ETFs See Record Volume at Key Support]

For more information on short strategies, visit our inverse ETFs category.

Max Chen contributed to this article.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.