Eric Dutram: With the major U.S. stock indexes hovering around their all time highs, it can be safely argued that risk on attitude has totally swept the market. Investors’ flight to safety seems to have taken a back seat, putting pressure on bonds across the board.
Be it the Fed-induced liquidity that is driving the markets higher or a better looking economic picture across the globe that is causing the market surge, one thing is certain—investors are back in the market.
In 2013 alone, the equity mutual funds and ETFs have seen a massive surge in asset inflows. However, is the flow of money into equity funds at the expense of sell-offs in bonds, or is it the fresh money being flown into equities?
For that could be a different matter of discussion altogether. In fact, with so much of money being circulated in the economy it is kind of hard to figure that out.
Considering the series of monetary easing measures of the Fed in the recent past, it was primarily aimed at playing the role of a catalyst to stir up an economic recovery. Also, another motive was to induce investors to take on more risk and thereby get the economy moving again.
And with the stock markets surging as well as a series of economic indicators pointing towards the positive side, it can be said that the primary goals of the monetary easing has been achieved. Even if that meant a massive expansion in the Fed’s balance sheet and increase in the U.S. debt burden (read Three Country ETFs Struggling in 2013).
With this backdrop, a spike in the interest rates across the board could come sooner rather than later, as the excess liquidity has to be sucked back when the economy is back on track. However, the key question still remains: when? Nevertheless, speaking of bonds as an investment vehicle, things look extremely dicey at the present moment.
High yield corporate bonds have reached a point where their issuing companies face the risk of defaulting on their payment obligations merely due to the size of their debt burden in their balance sheets.
Treasury bonds yields have been inching upwards as investors get back to equities. Also, with the already low Treasury interest rates in place, there is very little room for a further rate decrease.
On the other hand, emerging market bonds which attract investors due to their high yields face serious currency risk. This is especially true considering the strength exhibited of late by the U.S. dollar versus other currencies (see Emerging Market ETFs to Soar in 2013?).
However, investment grade corporate bonds look decent enough as they offer relative stability and decent yields without the risk of default. But, the upside is capped primarily due to the extremely low interest rate scenario in the economy.
Given the present circumstances, it might be interesting to look into some inverse bond ETFs to capitalize on any interest rate spike in the economy.
Fortunately, there are a number of choices out there for investors, although they tend to be heavily concentrated in the Treasury bond space. Still, these could very well be great plays if interest rates creep higher, suggesting investors should take a closer look at the following niche ETFs:
For a conservative mindset, the ProShares Short 20+ Year Treasury ETF (NYSEARCA:TBF) seeks to provide daily inverse exposure to the Barclays Capital U.S. 20+ Year Treasury Index.
This benchmark is comprised of Treasury Bonds having a residual maturity of 20 years or more. The ETF can be considered a more conservative product as it provides -1x exposure to long term treasuries.
Furthermore, its performance is just a mirror image of the performance of the iShares Barclays 20+ Year Treasury Bond ETF (NYSEARCA:TLT) which measures the regular performance of the same index. It charges investors 95 basis points in fees and expenses.
However, its leveraged counterpart, the ProShares UltraShort 20+ Year Treasury ETF (NYSEARCA:TBT) can exhibit huge moves in a portfolio. Due to its 2X inverse exposure, the returns may vary substantially than the targeted factor over long time periods, due to compounding.
The ETF seeks to provide twice the daily inverse exposure to the same index as TBF. TBT charges investors 92 basis points in fees and expenses.
Finally, aggressive investors can consider the Direxion Daily 20+ Year Treasury Bear 3x ETF (NYSEARCA:TMV) and the ProShares UltraPro Short 20+ Year Treasury ETF (NYSEARCA:TTT) for 3 times the daily inverse exposure to long term Treasury bonds having a residual maturity of more than 20 years. Needless to say that in term of exposure to risk, both these ETFs are much higher up the hierarchy.
TMV and TTT, both charge investors 95 basis points in fees and expenses.
In order to highlight the effects of the aforementioned ETFs in a portfolio, the above graph is shown. The chart compares the returns of the ETFs with the performance of TLT. And not surprisingly, as we have already discussed, the ETF with higher compounding multiples exhibit greater volatility.
Therefore, they are not good candidates for a buy and hold strategy, but could be interesting picks if interest rates continue to rise in a bullish trend over the next few weeks.