This Bond Bet Could Destroy Your Portfolio

The bond market has been teetering on the precipice for a long time now. If you're bearish on bonds and think interest rates are poised to jump higher in the near future, you're definitely not alone. If you want to profit from higher rates, though, you may need to steer clear of the crowd.

Just as aggressive ETF investors took both bullish and bearish positions on stocks during the financial crisis using leveraged ETFs, so too are some turning to the bond-market versions of these ETFs to try to multiply their returns. Although that strategy may work for short-term investors, the structural attributes of leveraged ETFs make this a potentially dangerous strategy for those betting on a more long-term macroeconomic trend.

Bonds and you
Over the past decade, bonds have done exactly what they're supposed to do in a diversified portfolio: protect investors from adverse conditions in the stock market. When stocks were rallying from early 2003 to late 2007, bonds didn't come close to keeping up with explosive gains in the equity markets. But they did manage to grow steadily as the economy slowed down. And during the market meltdown, those who had a sizable portion of their portfolios in the safest types of bonds took much less damage than those who were aggressively invested with a stock-heavy portfolio.

That trend has started to reverse recently, at least in certain parts of the bond market. Since the end of August, the iShares Barclays 20+ Year Treasury ETF (NYSE: TLT  ) has dropped 16% -- a huge drop that has shocked some conservative investors who believed that bonds were a safe place to put their money. Even the intermediate-term iShares Barclays 7-10 Year Treasury ETF (NYSE: IEF  ) , whose focus on shorter maturities are designed to make it less volatile than its long-term cousin, has lost more than 6% of its value in less than six months. To put the losses in perspective, with seven-year Treasuries yielding about 3% right now, it would take two years of interest payments to get investors back to breaking even.

Other parts of the bond market are showing mixed results. Municipal bonds haven't recovered from their year-end slump, as the iShares S&P National Muni ETF (NYSE: MUB  ) is also down more than 6% from its summer highs. On the other hand, corporate bonds are performing quite well as the stock market rebounds, especially high-yield junk bonds that tend to be closely tied to the fortunes of stocks.

Going for broke
Leveraged ETF investors see these moves and want to make the most of them. With ETFs designed to double the inverse returns on ETFs like these, a down move for bonds is a profit opportunity for leveraged ETFs.

That bet has paid off recently. The ProShares UltraShort 20+ Year Treasury ETF (NYSE: TBT  ) is up close to 25% since August. A similar leveraged fund for intermediate Treasuries, ProShares Ultra Short 7-10 Year Treasury (NYSE: PST  ) , has jumped 12% just since the end of October.

The problem, though, is that over the long haul, such bets can turn out to be losers even when you seem to make the right call. Since early 2009, the iShares long-term Treasury ETF has dropped an average of 3.2% annually. With those figures, you'd expect to see decent gains for the corresponding leveraged bond-bear ETF. But in actuality, that fund has done even worse, losing a whopping 8.9% per year. The figures are even worse when the market moves against you -- intermediate-term Treasuries have returned an average of 2.6%, but the bond-bear ETF is down more than 12% annually.

The apparent disconnect stems from the way these ETFs are designed. The funds do an excellent job at accomplishing their stated purpose of giving investors leveraged returns on a daily basis. Over longer periods, though, you simply can't expect to get double-sized returns from these funds unless the underlying market moves your way for a long time.

The better bet
If you want to bet on higher interest rates over the long term, leveraged ETFs aren't the answer. Instead, consider stocks that will benefit from higher rates. Brokers E*TRADE Financial (Nasdaq: ETFC  ) and Interactive Brokers (Nasdaq: IBKR  ) , for instance, get a lot of income from interest on their customers' uninvested cash balances when rates are higher. Short-term rates near zero have hurt their earnings since that cash earns next to nothing now, but when rates rise, some of that income should get restored quickly.

ETFs can be useful tools, but they don't always get the job done. By looking for better-connected investments, you'll be able to avoid pitfalls and get the results you're looking for.

You don't need leverage to earn strong returns with ETFs. Click here to read The Motley Fool's special report on ETFs, "3 ETFs Set to Soar During the Recovery" -- it's absolutely free.

Fool contributor Dan Caplinger was way early thinking the bond market would reverse course. He doesn't own shares of the companies or ETFs mentioned in this article. The Fool owns shares of Interactive Brokers Group, which is a Motley Fool Stock Advisor choice. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy is always a great bet.


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  • Report this Comment On February 08, 2011, at 11:10 PM, 2humble2fool wrote:

    This has to be about the fifth article on MF that I have read about the fact that leveraged ETFs are not good long-term investments, but none really have said why they're not. Very simply - does anyone think that leverage comes free? Not a real sophisticated concept, but I thought it could be clearly stated.

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