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By Timothy Strauts

The sharp rise in interest rates over the past month has caught many investors by surprise. Yields on 10-year Treasury bonds have risen from 1.6% to 2.1% since May 1. During this period, iShares Barclays 7-10 Year Treasury Bond ETF (NYSEARCA:IEF) declined 3.2%. The prospect that yields may march higher has many bond investors seeking protection from interest-rate risk. Some are rotating into shorter-duration fare, others are investing in floating-rate instruments, and some may even be considering an exchange-traded fund that provides inverse exposure to Treasury bonds.

The thought process of the last group might go something like this:

"I have a large fixed-income portfolio and I'm concerned about rising interest rates. I don't want to liquidate all or a portion of my fixed-income portfolio, because I rely on the income that these bonds are producing. I would like to find a way to hedge my interest-rate risk with a small portion of my portfolio. If interest rates rise, long-term bonds will suffer the most given their high duration. So if I buy a double-leveraged inverse-bond ETF on long-term Treasuries, I will be able to insulate my fixed-income portfolio with a relatively small allocation to the inverse ETF."

Is this investor onto something? Let's take a closer look at ProShares UltraShort 20+ Year Treasury (NYSEARCA:TBT) to find out.

Double-Short Inverse Treasury ETF
ProShares UltraShort 20+ Year Treasury seeks daily investment results, before fees, expenses, and interest income earned on cash and financial instruments that correspond to twice (200%) the inverse of the daily performance of the Barclays 20+ Year U.S. Treasury Index. That means that when the Barclays 20+ Year U.S. Treasury Index is down 5% for the day, this fund should be up 10%, and vice versa. The ETF typically tries to capture this return by taking positions in derivative instruments--typically swaps and futures contracts.

Investors should bear in mind that this fund likely will not deliver exactly double the index's inverse return over holding periods lasting longer than a single day. The chart below shows the returns of ProShares UltraShort 20+ Year Treasury and iShares Barclays 20+ Year Treasury Bond (NYSEARCA:TLT). Both funds track the same index. Since Oct. 1, 2011, TLT's returns declined by 1.21%. Those that fail to understand the compounding arithmetic inherent in this fund's long-term returns might expect that TBT would have returned a positive 2%-3% over this same span.

As can be seen below, TBT actually declined by 11.76% during this period. For a more thorough explanation of the thorny issues facing leveraged ETFs read, "Warning: Leveraged and Inverse ETFs Kill Portfolios."

(click to enlarge)
Source: Morningstar.

This example highlights the problems and adverse effects of a common misunderstanding that persists among investors with regard to leveraged and inverse ETFs. A combination of poor timing and volatile, non-trending market moves will likely mean that those using these funds will lose money while they wait for their thesis to pan out. Even in the unlikely event of perfect timing, those using these funds will probably not experience anything close to negative 2 times the return of the underlying index unless the index trends consistently in the same direction. Volatile markets are a worst-case scenario for leveraged products. The only way to mitigate the problems posed by the daily compounding within these funds is to rebalance one's allocation to the fund on a daily basis back to its original portfolio weight. This is a time intensive and expensive way to hedge a portfolio.

Alternatives
One of the best ways to moderate interest-rate risk is to reduce portfolio duration by reallocating into shorter-maturity securities. Here are some of our favorite short-duration fixed-income ETF options.

Vanguard Short-Term Corporate Bond Index (NASDAQ:VCSH) tracks a portfolio of bonds with maturities ranging between 1 and 5 years. The fund has a current yield to maturity of 1.30% and a duration of 2.9 years. VCSH has a very competitive expense ratio of 0.12%.

PowerShares Senior Loan Portfolio (NYSEARCA:BKLN) owns a portfolio of bank loans. These loans are variable-rate, senior secured debt instruments issued by non-investment-grade companies. Interest rates on bank loans are adjusted every 30-90 days, which results in an average duration near zero for this ETF's portfolio. Despite the ETF's very low duration, it still has an above-average SEC yield of 3.8%. This is because bank loans are below-investment-grade securities--so the above-average yield is reflective of above-average credit risk. This risk is somewhat mitigated by the fact that bank loans are senior in the capital structure and have first claim on the issuer's assets in the event of a bankruptcy.

PIMCO 0-5 Year High Yield Corporate Bond (NYSEARCA:HYS) offers exposure to high-yield bonds with between 0 and 5 years to maturity. The fund's portfolio has a duration of only 2 years. The portfolio has minimal interest-rate risk, but given that it invests exclusively in high-yield fare, it has a large amount of credit risk. High-yield bonds are traditionally one of the best-performing asset classes in a rising interest rate environment. This is because most periods of rising interest rates coincide with above-average economic growth, which bodes well for corporations' credit quality. HYS has a current SEC yield of 3%.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.

Source: Are Rising Rates Giving This Inverse ETF A Shot At Redemption?