(By Ron) As you may have heard, debt-ridden nations face sharply higher borrowing costs. Spain's ten-year government bonds are closing in on the 7 percent level.
That's the same area in which Greece and Italy both had to be bailed out last year … and Spain's problems are far bigger.
At the same time, relatively strong governments like Germany and the U.S. can finance their spending cheaper than ever. The yield on 10-year U.S. Treasury notes dropped below 1.5 percent last week. German government bond yields are even lower.
When interest rates fall, the present value of a bond goes up. That means capital gains for bondholders. Should you jump aboard this rally, or are trends bound to reverse? How can ETF investors react? Today we'll look at those questions.
Bond ETFs Shoot to the Moon!
Interest rate changes influence bonds in both directions:
- When interest rates go up, yields go up but bond prices go down.
- When interest rates go down, yields go down and bond prices go up.
Volatility increases along with maturity. A move of one-tenth of a percentage point is felt much more in a twenty-year bond than in a two-year bond.
The most rate-sensitive bonds of all are "zero coupon" Treasury securities. Because the income component is stripped out, what's left is almost purely dependent on interest rate changes. This is where recent trends have had the biggest impact.
For instance, take a look at PIMCO 25+ Year Zero Coupon U.S. Treasury Index Fund (ZROZ). In the ten weeks ended this past Monday (6/4), interest rates at that maturity level fell from 3.48 percent to 2.56 percent.
What did this do to ZROZ? Hold on to your hat. ZROZ shares shot up +30.5 percent! And that's without any leverage!
At these maturities, the ten-week price gain was equal to about 10 years worth of yield income. That's an acceleration of about 52x — converting years into weeks.
Hindsight Always Works
Opportunities like this one are always easy to spot in hindsight. Buying — and selling — at just the right time isn't so simple, of course.
If long-term U.S. Treasury yields keep falling, ZROZ could move much higher. But the losses will be equally dramatic if yields head back up.
To illustrate, let's go back to late 2010 and early 2011. Over a roughly five-month period, ZROZ investors saw their principal value drop by nearly a third. The share price went from $92.19 on August 26 to $64.18 on February 10, 2011. That's a 30.4 percent loss — one that would take years to break even from collecting the dividend.
As we now know (again, with the benefit of hindsight), selling ZROZ at the bottom of this downturn was exactly the wrong decision. Buying would have been a much better move.
Using Bonds in Reverse
If the interest rate trend turns around, you'll see big moves in another category, too. Inverse bond ETFs and ETNs are designed to move up when bond prices fall.
Like all inverse exchange-traded products, these have limitations. Typically they reflect the daily percentage change of an index. Results for periods longer than one day can look much different than you might expect. This means inverse ETFs and ETNs are best used as short-term trading instruments.
Timing is particularly challenging for inverse bond ETFs. As you see in the examples above, interest rates are prone to sharp, unexpected changes. Why? Usually it happens when a politician or central banker says something unexpected. The resulting market reaction may be temporary, but it's no less painful.
Bad luck can make a big difference even if you do everything else right. I've seen trades swing by 10 percent or more in just a day or two. (You can learn more in my column Three Often Overlooked Risks of Inverse ETFs.)
Assuming you're aware of the risks, long-maturity inverse bond instruments can have big profit potential. Here are some to consider:
- ProShares Short 20+ Year Treasury ETF (TBF)
- Direxion Daily 20 Year Plus Treasury Bear 1x Shares (TYBS)
- ProShares UltraShort 20+ Year Treasury ETF (TBT)
- PowerShares DB 3X Short 25+ Year Treasury Bond ETN (SBND)
Be ready for an especially wild ride if you buy TBT or SBND — they add 2X or 3X leverage to an already-volatile investment.
Interest rate forecasting is tough even in normal times. Right now it's even tougher — but if you're up to the challenge the profits can be huge. ETFs can make your job much easier no matter which way rates are going.
And if you'd like some help along the way in finding the right ones, with my signals on when to buy and when to sell, check out my International ETF Trader service.
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