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
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
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
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
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.
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.