Boring Bonds Become More Interesting

Bond prices and interest rates have been volatile lately, which means they can offer investors both trading and investment opportunities. ETFs are an ideal way for retail investors to participate in this market if so desired, and we’ll take a look at some ETFs that can give you both long and short exposure to this market.

As you probably know, bond prices move inversely to interest rates. When interest rates rise, bond prices fall, and when interest rates decline, bond prices rise. Sophisticated investors have been making bets on the rise and fall of bond prices for years through the futures market and now retail investors can use ETFs to participate in these markets, as well.

On the “long” side, an ETF worthy of consideration is IEF, iShares Barclays 7-10 Year Treasury Bond Fund.

This ETF is offered by iShares, one of the big hitters in the ETF world, and tracks the total rate of return for this actively traded, intermediate term sector of the US Treasury market. It has assets of more than $2.5 billion and more than 29 million shares outstanding and offers enough liquidity to be actively traded or held as an investment position.

Chart courtesy of StockCharts.com

iShares offers a number of other fixed income products that could also be suitable for investors wanting to participate in the Treasury market. For shorter term maturities, investors could consider SHY , the iShares 1-3 Year Treasury Bond Fund ETF. This one tracks the short term Treasury market, has total assets of more than $7 billion and more than 80 million shares outstanding.

On the “short” side, a way to get inverse exposure to bond market action is by using PST or TBT, two inverse funds from ProShares that move at twice the rate of the underlying index. These are leveraged funds and so investors need to understand that they’ll move twice as fast as the index and so be substantially more volatile. Position size needs to be carefully considered if an investor wants just 1X exposure to this market.

PST is the ultra short 7-10 Year Treasury ETF and TBT is the ultra short 20 Year Treasury ETF, both offered by ProShares.

Fluctuating bond prices offer both trading and investing opportunities. Whether investors believe interest rates are going to rise or fall, these sophisticated vehicles are available to gain exposure to this dynamic market.

Disclosure: TLT

Comments

[reluctantQuant:]

The author illustrates effective ways to obtain exposure to these sectors via the stock market, but longer term investors should beware the tracking error of these ETF's. One can never completely match specified asset returns via a "proxy asset" like ETF's and ETN's. For short term directional traders and hedgers, tracking error is unlikely to be an issue. But a long term investor is generally better served by buying an actual asset in the desired class.

Don't put Grandma in a treasury or tips ETF. Buy her the real thing direct from the treasury. Put her in a low low cost bond mutual fund for Munis. Less friction, less basis risk, less tracking error, more take-home return.

A drastic example of such tracking error is clarified if you compare the monthly returns generated by the USO ETF (oil) versus spot Crude prices over the last 3 years -- look at a 2 series chart if you have the tools. While the ETF clearly has utility in caputuring trends for a tactical investor, its longer term performance would get any manager fired. Alas, it's tough to buy commodities as a retail investor. But not so true for bonds...

--rq

Jul 01 09:19 AM

[John Nyaradi:]

Hi, Reluctant Quant,

thanks for your very good comments.

I agree completely,
John Nyaradi

Jul 01 10:57 AM

[morph366:]

"Position size needs to be carefully considered if an investor wants just 1X exposure to this market."

I'm not sure that I understand the remark above from your article.
The two short leveraged funds you mentioned will carry twice as much volatility risk as a non-leveraged holding and with twice the potential reward/loss. How would position sizing address that?

Jul 01 02:05 PM

[American in...:]

I disagree. Tracking error has not been a problem for the Vanguard funds. Frankly your comments sound like someone who wants to sell bonds to Grandma.


On Jul 01 09:19 AM reluctantQuant wrote:

> The author illustrates effective ways to obtain exposure to these
> sectors via the stock market, but longer term investors should beware
> the tracking error of these ETF's. One can never completely match
> specified asset returns via a "proxy asset" like ETF's and ETN's.
> For short term directional traders and hedgers, tracking error is
> unlikely to be an issue. But a long term investor is generally better
> served by buying an actual asset in the desired class.
>
> Don't put Grandma in a treasury or tips ETF. Buy her the real thing
> direct from the treasury. Put her in a low low cost bond mutual
> fund for Munis. Less friction, less basis risk, less tracking error,
> more take-home return.
>
> A drastic example of such tracking error is clarified if you compare
> the monthly returns generated by the USO ETF (oil) versus spot Crude
> prices over the last 3 years -- look at a 2 series chart if you have
> the tools. While the ETF clearly has utility in caputuring trends
> for a tactical investor, its longer term performance would get any
> manager fired. Alas, it's tough to buy commodities as a retail investor.
> But not so true for bonds...
>
> --rq

Jul 04 10:56 AM

[John Nyaradi:]

Let's say that in a $100,000 trading account you usually risk 1% of equity, or $1,000 per trade. In a standard ETF with a 10% stop loss, you would invest $10,000 for a risk of $1,000.

In a leveraged ETF you could invest $5,000, use a 20% stop loss to account for the 2x movement compared to the underlying index and achieve the same 1% portfolio risk, thus effectively achieving a 1x portfolio risk with a leveraged ETF.

By cutting your position size in half, you can get 1x portfolio exposure risk to these markets.


On Jul 01 02:05 PM morph366 wrote:

> "Position size needs to be carefully considered if an investor wants
> just 1X exposure to this market."
>
> I'm not sure that I understand the remark above from your article.
>
> The two short leveraged funds you mentioned will carry twice as much
> volatility risk as a non-leveraged holding and with twice the potential
> reward/loss. How would position sizing address that?

Jul 04 04:34 PM