Inverse bond ETFs, funds that essentially short government bonds, have had a phenomenal year. The ProShares Short 7-10 Year Treasury ETF (TBX) Increased 13.43% year-to-date and the ProShares Short 20+ Year Treasury ETF (NYSEARCA:NYSEARCA:TBF) is up 29.20%, while the S&P 500 (SPY) fell by 17.34%. Both funds rose initially yesterday after announcing inflation was at 8.3% in August, against expectations that it would fall slightly, although TBF closed out the day. Both funds ended the day with a more than normal premium of 0.07% to net asset value, potentially indicating a correction could take place. Nevertheless, given that inflation is embedded in the economy, further gains on these ETFs are highly likely.
Inverse bond funds are doing well thanks to the Federal Reserve’s fight against inflation. To get inflation under control, the Fed has been raising rates since March and is expected to further increase its target range for the Federal Funds rate by at least 0.75% at its Federal Open Market Committee (OTCPK:FOMC) meeting next week. Fed funds are the main policy rate of the FOMC and determine the interest rate at which banks lend their excess reserves held with the Fed to each other overnight. At the same time, the Fed is selling some of its assets, such as government bonds, which reduces the money supply in the economy. Since April, there has been little growth in the money supply (measured by M2).
Seven Inverse Treasury ETFs
There are currently only seven ETFs available that essentially short government bonds. Because inverse bond funds short bonds, they use leverage, which is a multiple of the amount of short the fund has relative to the seed capital it holds. Five of the inverse bond ETFs contain leverage multiples of two (-2x) or three times (-3x) (the minus sign indicates they are short). The more leverage the fund has, the riskier it is. Note that inverse bond ETFs don’t actually short bonds; instead, fund managers achieve their short targets primarily through swap agreements and a small amount of short selling of interest rate futures contracts. It is cheaper to replicate a short bond position this way rather than shorting it directly.
In Table I I summarize the seven inverse bond funds. All ETFs with maturities over 20 years have higher assets under management (AUM) than the 7-10 year ETFs. Given that we are in an environment of rising interest rates, this makes sense because the bond funds with maturities over 20 years have modified maturities of 18.29 years and the 7-10 years 7.97 years.
Modified duration measures how much a bond’s price will change with a change in interest rates. A higher maturity means a greater price change. When interest rates rise, bond prices fall – not good for long bond portfolios, but perfect for short portfolios, given the inverse relationship between interest rates and bond prices. Therefore, the prices of short bond funds rise when interest rates rise. In addition, since the longer the duration of a bond portfolio, the more sensitive it is to interest rate changes, the prices of high-duration short bond funds will appreciate more than those of lower duration bond funds. Hence the popularity of the 20+ year bond ETFs over the 7-10 year funds.
Note that all of these inverse funds have high expense ratios compared to the iShares long Treasury ETFs shown in Table I. It is important to remember that these reflect the costs of direct management of the fund and do not include the costs associated with keep in mind their leverage. The costs due to leverage reduce the returns of the funds, on top of the expense ratios.
The most popular inverse bond fund by assets under management (AUM) and trading volume is the ProShares UltraShort 20+ Year Treasury ETF (NYSEARCA:NYSEARCA:TBT) with $1.1 billion in assets under management. Direxion Daily 20+ Year Treasury Bear 3x Shares (TMV) is second in terms of AUM, with $545 million under management, while TBF is second in terms of daily trading volume. A critical metric for investors to be aware of is the risk of these ETFs, shown in the last column of Table I. The leveraged funds -2x and -3x have huge risks, with the -3x funds standard deviations of more than 42% have .
In Table II I summarize the cumulative returns of these inverse funds. This table shows the exceptional performance of these funds over the past year. The ProShares UltraShort 20+ Year Treasury Fund TBT is up 63.23% and the ProShares UltraPro Short 20+ Year ETF (NYSEARCA:NYSEARCA:TTT) has won 100.78%. All of these inverse bond funds have had upward momentum since early August, with TBX rising 5.21% and TBF rising 7.16% over the past month.
As can be seen in Chart I below, TBF’s AUM has fallen since February, along with the number of shares outstanding, a pattern that also applies to the other short-bond ETFs. Since the price of TBF has not fallen over this period, this reduction in the number of shares outstanding indicates that the authorized participants of this fund have repurchased their ETF shares into ProShares. An authorized participant is a financial institution that usually acts as a market maker in the funds for which they are authorized, and can create or reduce the number of outstanding shares an ETF has. They do this through ETF baskets that contain all the positions of an ETF. To reduce the number of ETF shares outstanding, they repurchase their shares from the sponsor, and in return they receive ETF baskets back; to create new ETF shares, they do the opposite: they give the sponsor ETF baskets and receive new ETF shares in return.
The Fed Funds Rate drives returns to these funds
As mentioned earlier, rising Fed Funds interest rates are one of the main determinants of inverse bond fund prices. Chart II shows the relationship between the Fed Funds rate, 5-year inflation expectations and TBF’s share price. TBF’s concurrent correlation with the fed funds rate since early last year is 0.78. The other major determinant is inflation expectations. The 5-year inflation expectations as calculated by the Cleveland Federal Reserve have a correlation with the TBF share price of 0.72. I checked several measures of inflation expectations and found that this 5-year measure from the Cleveland Fed had the highest correlation with TBF’s stock price.
Not too late to capture the momentum
With inflation remaining high, we can assume inflation expectations will rise again, and we can expect the Fed to continue raising Fed Funds interest rates and selling assets off its balance sheet. As mentioned, the prices of these funds have been rising since early August in anticipation of the Fed rate hike next week, and as Fed interest rates continue to rise next year, upward pressure on the prices of these funds will continue. funds.
The question that remains is whether the inverse bond funds will continue their upward path, or is it too late to get involved? Given yesterday’s inflation data, I suspect it’s not too late, although the effect of yesterday’s inflation announcement will be factored into their prices very quickly. Inflation is now embedded in certain aspects of the economy, such as rent costs and food prices. Given the history of inflation and interest rates experienced in the 70s and early 80s, the Fed may very well have to push the Fed Funds rate to 8% to lower inflation. This is significantly higher than the market expects, leaving room for upward movement in the prices of inverse bond funds.