Risks and Benefits of Inverse Bond Funds
Purpose, Design, and Risk
Investors who buy an inverse ETF for bonds are making a bet that bond prices will fall. These ETFs present a certain measure of risk that requires a level of acumen and market savvy that most investors don’t have. Keep this in mind as we walk you through the details of what these ETFs are, how they work, and what their pros and cons are.
What Are Inverse ETFs for Bonds?
Inverse bond ETFs are exchange-traded funds that are designed to move in the opposite direction as their target bond index. If the bond index is falling in price, the inverse bond ETF will rise in price. Because of the nature of inverse bond ETFs, investors may buy them when they believe that bond prices will fall.
Since the performance of inverse bond ETFs is opposite of the target bond index, they can be used as hedges (protection) against losses in the bond market. Also, since bond prices generally move in the opposite direction as interest rates, inverse ETFs for bonds are considered hedges against interest rate risk.
For example, if interest rates rise, bond prices will fall. To protect against falling bond prices, investors may buy an inverse bond ETF as a hedge.
This is unlike conventional bond funds, which are generally held by investors who hope to generate returns, expecting that bond prices will rise over time.
How Inverse Bond ETFs Work
To get their opposite performance, inverse ETFs use derivative investment securities, such as futures contracts and options. If you buy an inverse bond ETF, it will use a bond index as its benchmark index.
For example, if an index falls in price by 1%, the inverse bond ETF for that index would seek to deliver a 1% gain.
Leveraged Inverse ETFs
An inverse bond ETF may be designed to provide more than equally negative performance in the opposite direction of its benchmark.
These types of inverse ETFs are known as “leveraged ETFs” and often include the word “ultra” in their name. Inverse ETFs typically come in three different levels of correlation: -1x, -2x, or -3x.
For example, a common benchmark/target index for bonds is the Barclays U.S. Aggregate Bond Index. A -3 inverse bond ETF that tracks this index would be expected to have -3 times the gain, or a 3% gain if the index had a -1% decline (-3 x -1 = 3).
The opposite is also true. This -3 inverse bond ETF would incur a 3% decline in value if the benchmark index had a 1% gain (-3 x 1 = -3).
Inverse Bond ETF Reset Periods
It’s important for investors to understand that the performance of inverse ETFs can differ significantly compared to the benchmark index when held for more than one day. A holding period for weeks or months will dramatically increase this effect. This is because inverse ETFs reset their leverage. If the inverse ETF resets its leverage on a daily basis, the compounding effect can make your gains or losses extreme.
Consider this example from the Financial Industry Regulatory Authority (FINRA):
"Between December 1, 2008, and April 30, 2009, a particular index gained 2 percent. However, a leveraged ETF seeking to deliver twice that index's daily return fell by 6 percent—and an inverse ETF seeking to deliver twice the inverse of the index's daily return fell by 26 percent."
Risks and Benefits of Inverse Bond ETFs
There is one primary risk and one primary benefit of investing in inverse bond ETFs.
As with all capital markets, the bond market is difficult to predict. Since an investment in inverse bond ETFs is like placing a bet that bond prices will fall, investors lose if bond prices rise. This makes inverse bond ETFs speculative investments, which can potentially have greater market risk than conventional bond investments.
Hedge Against Rising Interest Rates
Since inverse bond ETFs move in the opposite direction of their target benchmark, investors can benefit by using them as a hedge against rising interest rates and falling bond prices. Hedging strategies are primarily employed by sophisticated investors and financial institutions.
When to Buy Inverse Bond ETFs
The ideal environment for inverse bond ETFs would generally coincide with a healthy and growing economy. In these seasons of growth, the Federal Reserve Board of Governors often raises rates to fight inflation.
This season of growth is best for this is because bond prices generally fall when interest rates rise. Bond prices fall in a rising interest rate environment because the new bonds that pay higher rates are more attractive than the old bonds that are paying lower rates.
Subsequently, when bond prices fall, prices on inverse bond ETFs will rise, thus, benefiting the investor.
If we’re in the midst of a healthy economic and rate environment, inverse bond ETFs may not be worth buying while assuming the added market risk.
The Bottom Line
Inverse ETFs for bonds can make a good hedge against rising interest rates and falling bond prices. However, the complexity and speculative nature of these funds make them pretty inappropriate for most investors.
Mastering inverse ETFs for bonds requires that you accurately forecast economic conditions and the direction of interest rates. The average investor may not be able to do this well or consistently.
Investors should keep in mind that investing in inverse bond ETFs is not the same as investing in conventional bond ETFs, bonds, or bond mutual funds. Bonds are generally considered to be low to moderately low-risk investments because of their relatively stable price. Inverse bond ETFs, however, are considered high-risk.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.