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Overview

With actions by the Fed continuing to support historically low rates, many investors are trying to determine when quantitative easing will begin to dissipate and interest rates begin to rise. It is very difficult to predict if this will happen, let alone when, so one has to take a long term view if they want to profit from rising rates. Trying to call the bottom in rates has been a rough trade over the past few years, so I want to find a way to limit my risk in trying to make a bullish bet on rates.

Some of the most popular vehicles for betting on rising rates (falling bond prices) have been the ProShares ETFs TBF, TBT, and TTT. These ETFs aim to provide 1x, 2x, and 3x inverse returns to the daily performance of the Barclay's U.S. 20+ Year Treasury Bond Index. Though these are liquid ETFs which allow you to short U.S. treasuries, their structure makes it difficult to invest in them long term. Because these ETFs attempt to track the daily movement in the related index, they must rebalance their investments every day. This leads to a slow decay in the value of the ETF that can make long-term investing difficult. As of 3/31/13 the tracked index was up 7.61 % over the last year, with TBF, TBT, and TTT down 9.99%, 19.67%, and 28.4% respectively. This means TBF decayed 2.38%, TBT 4.45%, and TTT 5.57%. The reduced decay of TBF makes it appear the most attractive vehicle of the three for a long-term investment.

More risk for the same return

With this in mind, I want to demonstrate an additional difficulty in trying to short bonds. The problem lies in the "convexity" of bonds. This attribute of bonds holds that the change in the present value of a bond will increase more due a decrease in rates than it will decrease due to a similar increase in rates. The following example should help to visualize this property. The values below relate to a 3% 30-year bond with payments made semiannually.


(Click to enlarge)

The graph above shows that a 1% decrease in rates would result in a $224 increase in the value of the bond. However, a 1% increase in rates would result only in a $174 decrease in the value of the bond. This means an investor needs an even more pronounced increase in interest rates in order to make the same amount of profit vs. the amount of risk they are exposed to.

Avoid the extra risk

As the example shows, investors are taking on a hidden additional risk when betting against bonds at these levels. Why increase that risk by investing in an ETF with a large decay? The leveraged returns of TBT and TTT may seem tempting, but unless you are supremely confident yields will move up significantly in the short term, TBF appears to be the superior ETF vehicle for long term investors.

Source: The Safest Way To Play Rising Interest Rates