ETF Strategies For Volatile Interest Rates - Proceed With Caution

Includes: TBT, TLT
by: Michael Blair

Pro Shares Ultra Short 20+ Year Treasury ETF (NYSEARCA:TBT) is a double levered short play on the 20 year bond index, and iShares Barclays 20+ Year Treasury Bond ETF (NYSEARCA:TLT) is a short play on the 20 year bond index. TBT is a dangerous ETF in that it resets daily and tends to decline in value with volatility even if the trend in long-term treasuries is favourable to the ETF.

TBT - the short bet

As rates rise bond prices fall and TBT should rise, like it has done since May 2013, rising about 40% as bond yields rose. If rates continue to rise, TBT should rise as well.

TLT - the long bet

At the same time, with rising rates the value of TLT should fall, as it has since May 2013, falling about 17%. If rates continue to rise, TLT should continue to fall.

Both of these ETFs can be very profitable but they can also bite back. Since TBT resets daily, short-term volatility in bond rates can wreak havoc with their value even if bond prices and rates end up at the end of a holding period precisely where they started.

Investors wanting to benefit from rising or falling rates can use these ETFs. I like both but I don't like to own them directly, preferring to hold call options on TBT and put options on TLT. By holding calls on TBT and puts on TLT I am betting that rates will rise during the tenure of the options.

Using options limits risk if the movement in rates during the tenure of the options is adverse to the holding. Rapid movements in rates can be caused by many factors - financial, geopolitical, monetary policy, a spike in inflation, and so on. I am old enough to remember the day in October 1987 when then Fed chief Paul Volcker made a statement that the Fed was going to move from targeting interest rates to targeting money supply. In addition to a market crash of over 500 points on the Dow Jones, the remark caused a rapid rise in long term rates and many bond investors took a bath alongside their equity contemporaries.

These ETFs are not for the faint of heart but are worth considering as part of a prudently diversified portfolio in an environment where many factors point to higher rates, including:

  1. A likely end to Quantitative Easing as early as later this month;
  2. Expanding economies, albeit at a tepid pace
  3. Turmoil in Syria
  4. The possibility of a rise in inflation triggered by high oil prices, and,
  5. The unpredictable consequences of escalation of violence in the mid-East if the United States and its allies begin to become involved

So far, investment in TBT and an effective short in TLT have been solid trades with both positions in the money. My options expire January 2014 and I will review at that time whether the circumstances merit a continuation of the trade.

Disclosure: I am long TBT. 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 calls on TBT and puts on TLT