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At first glance, these ETFs seem like a simple way to hedge against rising interest rates. Upon further inspection, these funds should come with a warning label. Modern financial engineering can make even the safest investments risky. Even when most professionals agree that there is nowhere for interest rates to go but up, speculating on yield curve changes is not for the faint hearted. The performance of the ProShares Short Treasury ETFs has lagged.

Specifically, ProShares created several different short ETFs which are: TBF, TBX, TBT, TBZ, PST, and TPS. These ETFs allow investors to short the medium to long end of the yield curve as well as the inflation protected market. Both levered and unlevered forms exist. In 2011, the short ETFs performed poorly. In particular, the best performing Short Treasury ETF dropped by 14.2% while the worst performing ETF dropped by 48.9%.

Are the short Treasury ETFs due for a rebound? Possible appreciation is ahead; however, timing is very important. Significant negative carry must be paid by short investors. Without taking into account the coupons of the actual bonds in the funds, at the 7-year end of the curve, the yield-to-maturity is 1.375%. At the 30-year point the yield-to-maturity is 3.125%. Logically, the carry situation is worsened by leverage. In addition, expenses of approximately 1% must be paid to the fund administrator annually. Thus, if rates remain low, holding these investments long term could prove costly. A decline in treasury prices is necessary just to break even.

The alternative is a long Treasuries investment. ProShares has two long Treasury ETFs, UBT and UST. In 2011, they returned 64.9% and 29.4%, respectively. While these returns are terrific, the huge discrepancy is obvious. Deciding which point in the yield curve to choose and whether or not to be short or long is not trivial. Even though the investment is into a basket of Treasuries, returns can be quite volatile. In addition, yields are at historical lows. Further gains of this magnitude are unlikely.

Optimistically, predicting interest rates has never been easier. Federal Reserve Chairman Bernanke has moved toward greater transparency. The Fed’s objectives are clear. Currently, inflation is low and unemployment is high. Given that situation, it is unlikely that the Fed will push for monetary tightening.

Credit concerns also seem to be abating. In August the rating agencies took action. Standard and Poor’s downgraded the United States to AA+. The credit markets, as measured by these ETFs, did not respond. Even with heightened credit concerns, the returns to the Short Treasury ETFs were down the month of August. The worst being felt at 20-year maturity (TBT). While credit concerns in the United States are far from over, markets have come to some acceptance of the current debt levels.

So what will drive these toward ETFs higher levels? The negative carry is likely to be the dominant factor in the short term. Even with increased Federal Reserve transparency, yield curve dynamics remain difficult to predict. Investors looking for an inflation hedge or a hedge against higher rates you would be better off looking elsewhere.

There may be safer ways to play a rising rate environment. Some investors have chosen exposure to commodities. The most well-known investment has been gold through ETFs such as GLD. Unfortunately, this choice is popular and lacks a positive carry. Another less well known option is floating rate debt.

Source: Are Short Treasury ETFs Due For A Rebound?