This article will introduce an unconventional way to profit when interest rates rise using inverse ETFs. We will show the upsides and downsides of these tools, focusing on how they could be used in today’s American market. Inverse ETFs could be a useful tool to deal with the possible future bear shift in the bond market triggered by Trump election.

Trumponomics effects on rates

Donald Trump unexpected election has had a big impact on the US bond market. On the Election Day, US Treasuries recorded their biggest plunge in five years, with the 10-year benchmark yield climbing 20 basis points to 2.05%. The bond selloff went on in the following days: on 17th November, the 10-year yield was 2.30%, the highest reading since November 2015.

The selloff is the market reaction to the prospect of increased US fiscal stimulus under Trump presidency. During the campaign, the president-elect pledged to underpin economic growth with an ambitious trillion-dollar infrastructure plan and heavy tax cuts, aimed at creating new jobs and increasing productivity.

Trump’s plan seems achievable considering that the Republicans control not only the White House but also both chambers of Congress, putting an end to the political gridlock experienced under the latter Obama administration. If implemented, Trump’s public spending would remarkably increase the US public deficit, which will be funded with new issues of American debt.

Many analysts believe that the increased public spending and tax cuts could actually boost US economic growth. Moreover, as the US economy is very close to full employment (with an unemployment rate of 4.9% back to pre-crisis levels), the fiscal stimulus is likely to boost inflation too. As the chart below shows, market’s inflation expectations spiked as an aftermath of Trump election.

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Source: Bloomberg

The higher expectations about growth and inflation widespread concerns about a less accommodative FED policy, as the central bank could have to hike interest rates at a higher-than-expected pace to cool down an economy overheat by fiscal stimulus.

This week Janet Yellen stated that interest rates would be raised soon, clearly referring to the approaching FOMC meeting, which will be held on 4th December. Yields on 2-year notes, the coupon maturity most sensitive to monetary-policy expectations, rose to 1% for the first time since January. This spike in 2-year yield is not fully justified by FED Chair statement as the market has been pricing December’s rate hike since September, but shows that market players are looking beyond, focusing on the future interest rates path. At the moment, the FED is planning two interest rate hikes for next year but Trump policy could change their forecasts.

Market players seem to consider Donald Trump election as the political regime shift needed to mark a turning point for fixed income. According to this standpoint, what we witnessed in the bond market is a fundamental rethink in the near-term outlook, which resulted in US Treasuries trading at yields that economists and strategists had not been expecting until 2018.

Inverse ETFs

Many analysts consider Trump presidency the possible end of a two-decade bull run in the bond market. As yields and prices are inversely correlated, a general rise of interest rates will result in decreasing bond prices. The immediate investing idea could be shorting US Treasuries, but inverse ETFs could represent a compelling alternative.

Inverse ETFs are funds designed to replicate the inverse performance of a benchmark, investing in various derivatives, mainly swaps and futures but also money market instruments such as US Treasury Bills and repo. Inverse ETFs are used for profiting from a decline in the value of the underlying. This way, an investor who forecasts an increase in interest rates could profit by buying an inverse ETF tracking a US bond index, gaining as rates raise and bond prices fall. Inverse ETFs can be unleveraged (-1x) or leveraged (-2x or -3x).

It is important to point out that these funds seek to attain their goals on a daily basis. Because of this, inverse ETFs are usually recommended only for short-term trades as their performance could be either better or worse than the actual index performance in the long run. This difference is called tracking error and it is the result of each day’s slight price discrepancy between the ETF’s value and the underlying index, compounded over the period considered. Therefore, the bigger the holding period, the bigger the tracking error. The tracking error is magnified for leveraged funds.

Moreover, the tracking error is more pronounced as volatility increases. In other words, given the return of the tracked index, as its volatility picks up so the inverse ETFs performance get worse.  The table below shows the forecasted effects of volatility on an inverse ETF.

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Source: ProShares prospectus

Another important feature of inverse ETFs is their high Total Expense Ratio due to the fact that they are actively managed to track the underlying index on a daily basis. Inverse ETFs usually have annual expenses accounting for 0.95% against the average 20 basis points of a common ETF.

The strategy

Following our bearish prospects on the US bond market, our aim is devising an investment strategy that can profit in this environment. Our strategy is referred to a medium-long term time horizon to follow the upward trend in yields we forecast for the years to come. Inverse ETFs could provide us the opposite exposure to the market we need. We know inverse ETFs are recommended only for short-term trades because of their implicit tracking error. However, we believe inverse ETFs are the right tool to play the interest rates rise because we are not interested in carefully tracking an index, but rather to take the market’s opposite position.

Compared to short selling, which is the traditional way to bet against the market, purchasing an inverse ETF has at least two advantages. The former is that the investor is not required to hold a margin account. The latter is that the investor does not have to pay a fee to his broker to borrow the asset he is shorting.

A good way to take profit from interest rates hikes is shorting high-duration bonds because the higher the duration, the more sensitive is bond price to a change in rates. Duration is higher for long maturity bonds. Therefore, our idea is to play the yield increase through long maturity US Treasuries inverse ETFs.

Considering this criterion, a possible choice is the ETF ProShares Short 20+ Year Treasuries (ticker TBF), which seeks to provide the opposite performance of ICE US Treasury 20+ Year Bond Index. TBF fits our requirements with a high duration of 19.25 years.

ProShares offers also the leveraged 2x and 3x versions of TBF, respectively TBT and TTT. TBT is the largest and most popular ETF in the inverse bond space with asset under management worth more than $2.2 billion and an average trading volume of 2.5 million contracts.

Liquidity for TBT contracts does not seem to be a problem guaranteeing a tight bid-ask spread. However, the 2x leverage could be dangerous considering its magnifying effect on the fund’s tracking error. That is why we would suggest a more conservative approach, preferring the less liquid but safer TBF.

Moreover, the other element affecting the tracking error is the underlying index’s volatility. The ICE US Treasury 20+ Year Bond Index has an annualized historical volatility of 14.69%, calculated on the five-year period ended in May 2016. The historical volatility peak was 19.95% recorded in May 2012.

The relatively high volatility of the underlying turns into a higher tracking error of leveraged funds (TBT and TTT) if compared to the unleveraged TBF. The chart below shows the performance of the aforementioned ETFs compared to the benchmark (black line) affected by no tracking error, considering an initial investment of $1,000 in January 2014. The difference between the TBF (green line) and the benchmark is the tracking error. As the graph shows, the tracking error is amplified for leveraged funds.

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Source: BSIC

For a more conservative approach to volatility, there is ProShares Short 7-10 Year Treasuries (TBX), which seeks to provide opposite exposure to ICE US Treasury 7-10 Year Bond Index. Its historical volatility is 6.03%, remarkably lower than that of 20+ Year Bond ETFs. TBX lower tracking error offsets the fund’s lower duration, resulting in a risk-reward trade-off for investors.

As we showed in this article, ETFs provide investors with a number of interesting investment strategies to take profit from market conditions. We believe inverse ETFs are a powerful tool not only for professionals but also for the retail investor, as they are a compelling and easily accessible alternative to short selling. Indeed, retail investors can take advantage of the rising rates environment with these instruments, getting the inverse exposure they need with all the flexibility of an ETF.

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