Yields on 10-Year U.S. Treasuries have declined 2.8% in the past five days, but that drop barely dents the 56.3% year-to-date rise. Although the Federal Reserve has linked official rate hikes to U.S. employment data and promised to keep benchmark rates low for the foreseeable future, some bond investors have become jittery that a 30-year fixed income bull market is on the cusp of crashing to an end.
Bond prices and yields usually move inversely of each other, so the recent yield has caused significant capital destruction in fixed income portfolios, chasing investors to lower durations bonds and bond ETFs or out of debt instruments altogether. Duration is a measure of a bond’s sensitivity to changes in interest rates. The longer a bond’s duration or the duration on a bond ETF, the more vulnerable it or the fund is rising rates.
For example, the 30-year U.S. Treasury Bond with a duration of 20 will be about twice as sensitive to a change in yield as the 10-year U.S. Treasury Bond, which has a duration of 9. So, a 1% rise in the yield of the 30-year U.S. Treasury Bond could cause its value to decline by approximately 20%, whereas a similar increase in the yield of the 10-year U.S. Treasury Bond would cause a decline of about 9% in its value,” according to ProShares.
Still, some investors do not understand how rising rates can plague longer durations ETFs like the iShares 20+ Year Treasury ETF (NYSEArca: TLT). According to a survey released by Edward Jones last month, 63% of Americans don’t know how rising interest rates will impact investment portfolios such as 401(k)s, IRAs and other savings platforms. [Many Investors Don’t Understand How Rising Rates Kill Bonds]
ProShares highlights the capital and income destruction caused by rising rates, noting that just a 1% rise in interest rates could cause a $100,000 bond portfolio with a duration of six years to drop to a value of $94,000. A 2% increase in interest rates would wipe $20,000 out of a $100,000 bond portfolios with a duration of 10 years.
The notion of rising interest rates eroding bond investments has started to sink with investors. Since the start of August, TLT has seen outflows of nearly $293 million while investors have pulled almost $392 million from the iShares Core Total U.S. Bond Market ETF (NYSEArca: AGG) although AGG’s duration is just 5.1 years. [Outflows Show Bond Weakness Sinking In With Investors]
ProShares, the largest issuer of inverse and leveraged ETFs, notes that investors can take a more tactical approach and consider inverse bond ETFs as a way of coping with rising rates.
“Using inverse bond ETFs to hedge interest rate risk is an approach that can complement and enhance longer-term strategic moves,” said ProShares. Use of inverse bond ETFs does not require opening a margin, futures or other account that employs leverage. Investors can use funds such as the ProShares UltraShort 20+ Year Treasury (NYSEArca: TBT) and the ProShares UltraShort 7-10 Year Treasury (NYSEArca: PST), which have one-day return objectives, without disrupting a core fixed income strategy.
TBT is up 17% in the past three months while PST is higher by nearly 9% over the same time.
ProShares UltraShort 7-10 Year Treasury
ETF Trends editorial team contributed to this post. Tom Lydon’s clients own shares of TLT.