After falling to historic lows on heightened market volatility last year, U.S. Treasury yields are beginning to push higher. Looking ahead, as investors become more comfortable with riskier assets, the long end of the Treasury curve could continue to move upward. Reflecting this trend, Treasury related exchange traded funds have dipped below a key technical support level, but inverse Treasury ETFs are capitalizing on the moment.
For instance, the ProShares UltraShort 20+ Year Treasury ETF (NYSEArca: TBT), ProShares Short 20+ Year Treasury ETF (NYSEArca: TBF), ProShares UltraShort 7-10 Year Treasury ETF (NYSEArca: PST), ProShares Short 7-10 Year Treasury ETF (NYSEArca: TBX) and Direxion Daily 20+ Year Treasury Bear 3x Shares NYSEArca: TMV) provide decent exposure to the downside of the current Treasuries market. The ProShares "ultrashort" moniker indicates that they will try to provide twice, or 200%, the inverse of the daily performance of the Treasury market while the Direxion Bear 3x fund will try to reflect 300% inverse of the daily performance.
Treasury ETFs provide the average retail investor with a similar investment return to owning the actual Treasury bonds. As such, these funds reflect the safe-haven status of the Treasuries market. For example, during the Eurozone financial debt crisis and downgrade of the U.S. debt last year, Treasury ETFs outperformed as global investors sought the relative safety of the highly liquid U.S. Treasuries market.
The flight to quality has consequently rushed yields on long-term Treasuries dated over 20+ years to their mid-2% levels and the benchmark 10-year notes to near all-time lows of around 1.7%. In contrast, 20-year Treasuries over the past decade have provided average yields of 4.7% and 10-year Treasuries showed average yields of 3.7%.
More recently, the positive market sentiment has lifted investors' risk profile and brought yields back up. Treasury prices are falling on the stock markets forward momentum as investors realize that the U.S. economy hasn't fallen back into a double-dip recession and after the Federal Reserve announced its optimistic economic outlook. Additionally, the financial sector - a major cause of concern in 2008 and main contributor to the push into safe-haven Treasuries - passed the recent string of stress tests on its large banks. Investors are beginning to realize that stocks are rading at very cheap valuations as compared to fixed-income assets. Consequently, yields on the benchmark 10-year notes have expanded to four-month highs of 2.27% and yields on 30-year Treasuries ave hit 3.4%.
The iShares Barclays 20 Year Treasury Bond Fund ETF (NYSEArca: TLT), which tries to track long-term U.S. Treasury market, and the iShares Barclays 7-10 Year Treasury Bond Fund ETF (NYSEArca: IEF), which follows the intermediate-term U.S. Treasury market, have both recently fallen below their 50-day moving average and are closing in on their 200-day moving average. TLT now shows distribution yield of 2.90% and IEF has a distribution yield of 2.05%. Due to their longer time horizons, the two funds are more exposed to interest-rate and inflation risks. While we won't have to worry about interest-rate risks until late 2014 as the Federal Reserve is committed to keeping it at "exceptionally low" levels, inflation risks may pose a more immediate concern - inflation eats away at real returns on yields.
The Inverse ETF Option
In contrast, interest in short or inverse treasury funds are garnering greater interest. For instance, there has been evidence that institutional investors are using ETF options and inverse funds to position for the rising treasury yields over the past few months. Inverse ETFs bet against the direction of the financial markets, so they make money when the market or sectors are declining. Inverse funds may not perfectly reflect the performance of a specific market since they are rebalanced on a daily basis, hence the need for daily monitoring. These funds are not meant to act as long-term holdings because of compounding issues from daily rebalancing could result in unexpected long-term returns. Nevertheless, these investments are good hedging tools that could provide potentially profitable short-term exposure to an area of the market.
In anticipation of a higher inflation rate and depreciating U.S. dollar due to the loose U.S. monetary policies, investors may use inverse Treasury ETFs as a hedge against declining Treasury prices and rising yields. Those that believe the flight to quality will continue to reverse may monitor these inverse ETFs as an opportunity to speculate on the bearish moves within U.S. sovereign debt.
Potential investors should also note that these funds hold derivatives, futures and swap contracts to achieve their inverse and leveraged inverse objectives. Consequently, they will come with their own set of tax consequences, which may not be as favorable as those of passively indexed ETFs. All the positions are marked to market at year-end, so capital gains will not be deferred and potential profits trigger short-term taxable events.
Still, if you are wary about the geared products as a whole, you can always try and short the long-dated Treasury ETFs, like TLT or IEF. But in either case, it is important to fully understand how the investments work and how to efficiently capture the downside of a market with short trades.