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Recently I wrote an article titled "Why Long-Term Bonds are the 'Dumbest investment.'" This article is the first in a series to explore alternatives to holding long-term government bonds in a portfolio, and develop possible strategies to structure fixed-income, balanced and/or target retirement portfolios for a rising rate environment.

If the expectation is for interest rates to increase in the future, the obvious strategy would be to go long interest rates. The way an investor can go long interest rates is by buying an inverse bond fund. Whereas bond prices fall when interest rates increase, inverse bond funds increase in price when interest rates increase. They essentially are the mirror image of a bond. Here is a chart of the ProShares Short 20+ Year Treasury (NYSEARCA:TBF) and iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT) demonstrating their inverse behavior.

(click to enlarge)Inverse Bond Fund

A few things to note from that graphic:

1) Over the time period covered, TLT was up 29.53%, whereas TBF was down -40.11. Part of that is due to the law of compounding. If something falls 50% in value, it takes a 100% gain to get back to even.

2) TLT also has an expense ratio of 0.15%, whereas TBF has an expense ratio of 0.95%.

3) TLT holds bonds that accrue interest and has a 2.79% distribution yield. TBF has a portfolio of short futures that need to be constantly "rolled-over" which injects tracking error into the portfolio and don't accrue or pay interest.

This is a shorter term graphic that shows how the mirror-image is much closer over the short term than the long-term. Over this time period of slightly more than 2 years, TLT is up 31.98%, whereas TBF is down 34.54%. The price change is relatively close, but it also excludes the monthly dividend paid by TLT, so the total return difference is greater that the price change demonstrates.

(click to enlarge)Inverse 2

All those factors discussed above work together to distort the mirror-image, so the investor must be aware that the mirror-image isn't a perfect analogy. The above graphic however covers a period of declining interest rates, and we are most concerned with how it will perform in a rising rate environment.

This graphic highlights how the two ETFs performed during one of the rare episodes of increasing interest rates that has occurred over the last 3 years. During this period TBF increased by 10.08%, whereas TLT fell 8.73%. At least during this time period, TBF reversed some of the underperformance that developed during the period of falling rates. Unfortunately the fund hasn't been around long enough to measure its performance over an extended period of rising rates.

(click to enlarge)Inverst Bond

The above discussion covered only the 20+ year treasury bond ETFs. As this article titled "The Top 5 Inverse-Bond Fund" highlights, there are more. Word of caution: one of the top 5 funds discussed is the Direxion Daily 20+ Year Treasury Bear 3x ETF (NYSEARCA:TMV). That is a leveraged fund, and isn't applicable to the strategies being discussed in this series of articles. I Chose the above linked article because it mixed leveraged and unleveraged funds together, and investors have to be careful to be aware of the difference, and that articles often do not differentiate the two.

Here is a "Definitive List of Inverse Bond ETFs which includes the following ETFs:

Short Treasuries:

iPath US Treasury Long Bond Bear ETN (NASDAQ:DLBS)

ProShares Short 20 Year Treasury

Direxion Daily 20 Year Treasury Bear 1x Shares (NYSEARCA:TYBS)

iPath US Treasury 10-year Bear ETN (NASDAQ:DTYS)

ProShares Short 7-10 Year Treasury (NYSEARCA:TBX)

Direxion Daily 7-10 Year Treasury Bear 1x Shares (NYSEARCA:TYNS)

iPath US Treasury 5-year Bear Exchange Traded Note (NASDAQ:DFVS)

iPath US Treasury 2-year Bear ETN (NASDAQ:DTUS)

Short Total Bond Market:

Direxion Daily Total Bond Market Bear 1x Shares (NYSEARCA:SAGG)

Short Corporate Bonds:

ProShares Short Investment Grade Corporate(NYSEARCA:IGS)

Short Japanese Government Bonds:

PowerShares DB Inverse Japanese Govt Bond Future (NYSEARCA:JGBS)

Short High-Yield Bonds:

ProShares Short High Yield (NYSEARCA:SJB)

Further Discussion:

The definitive list also includes an ETN based upon movements of the yield curve that is technically not an inverse bond fund but is worth some discussion. The ETN is the iPath US Treasury Flattener ETN (NASDAQ:FLAT). For completeness, the list should have also included its inverse the iPath US Treasury Steepener ETN (NASDAQ:STPP). These funds would not be substitutes for long-term government bonds, but they define a strategy all to themselves. Whereas up to this point we have been discussing a parallel shift in the yield curve, where interest rates increase across the yield curve, these two funds are based upon the steepening or flattening of the yield curve.

These funds allow us to define a strategy based upon expectations of how the yield curve will behave going forward. In my opinion, the likelihood of the yield curve steepening is far greater than flattening over the short and intermediate term (1 to 3 years). The reason for this is because the Federal Reserve's policy intends to keep short term rates low for the foreseeable future, and only increase them once unemployment has improved to around the 6.5% rate. The old adage goes "don't fight the Fed." The Fed is effectively keeping a boot on the short end in an effort to stimulate the economy, and implicitly communicating that economic growth takes priority over fighting inflation. That implies that the Fed will be slow to allowing short-term rates to increase.

The current unemployment rate is near 8%, so if unemployment falls to 6.5%, it is likely the markets would be well on their way to discounting an economic recovery. If that were to happen, one would expect a parallel shift in the yield curve, but with the Fed keeping a boot on the short end, the Fed would effectively be creating a steepening yield curve. Additionally, I would imagine the Fed would stop "Operation Twist" (or similar programs where it uncharacteristically buys longer term bonds) before it starts increasing the discount and fed funds rate. That appears to be the message and strategy recently outlined by the Dallas Fed's president. Only AFTER the economy is well on its way to recovery would I expect the Fed to lift its boot off the short end, and then the yield curve would be expected to flatten, but I would expect that in the long-term (3 to 4 years), not the short or intermediate term. In fact, I would imagine the Fed would use increasing long term rates as an indicator that the economy is strengthening. Sustained economic recovery should drive long rates higher. Once long rates hit and sustain a level consistent with a stable and growing economy, then and only then should the Fed start to lift the short term rates. It makes no sense to me that the Fed would risk halting a recovery in its infancy by increasing short term rates before the long end has signaled a recovery is well under way. STPP allows the investor to financially benefit from the steepening of the yield curve, that in my opinion, is likely to occur. If an investor disagrees with my analysis, FLAT would allow them to participate if the yield curve flattens.

In collusion, inverse bond funds are one alternative to holding long term government bonds during a rising rate environment. They allow investors to "go long" interest rates. The available funds offer imperfect mirror images to their long bond counterparts. It is important for an investor to understand the risks involved with these funds, paying attention to whether or not the fund is leverage, and especially the duration of the fund. If an investor is replacing a 5 year treasury with an inverse 20+ year fund, they will not be buying its mirror image. Those risks need to be understood, and the investor should have a clearly defined expectation for where the yield curve is headed. If the expectation is that interest rates are going lower, or will remain flat, inverse bond funds would not be appropriate. FLAT and STPP are not substitutes for inverse bond funds, but are unique investments designed to capitalize on non-parallel shifts in the yield curve. In my opinion if an investor is interested in these funds, STPP would be a better investment in the short and intermediate term than FLAT, and then rotate out of STPP and into FLAT only after the Fed has started to increase the short term rates.

Disclaimer: Opinions expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment advisor capacity. This is not an investment research report. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings, and consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I hold TBF in my Mother's retirement Portfolio. I also write covered calls, or at least recently have attempted to write covered calls, off her position. In my own account I write cash backed puts off a leverage inverse bond fund TBT, of which I currently have an open position. I may sell covered call options on TBF within the next 72 hours for my Mother's account. This strategy helps boost her income.

Source: Strategies For A Rising Rate Environment: Inverse Bond Funds