Risks and Rewards of Leveraged Bond Funds

$1000 denomination US Savings Bonds
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In the past, investors who were looking for excitement certainly weren’t going to find it in the bond market—unless they were trading bond futures and options. Today, however, anyone can get more bang for their investment dollar by using leveraged bond funds or exchange-traded products (ETPs) or exchange-traded funds (ETFs). In this article, statements made about leveraged bond funds apply to leveraged bond ETFs as well.

The Relation Between Investment Risk and Reward

As is generally the case for all investments, the potential of leveraging for greater rewards brings with it added risk. As the name implies, leveraged bond funds are funds that leverage their returns by using borrowed money and/or derivatives to multiply investment returns. A three-times leveraged bond fund with $100M in assets from its investors, for example, may borrow another $200M against shareholder capital and use those borrowed funds to purchase more bonds on behalf of its investors, tripling their gains, but also their losses.

For another example, consider if U.S. Treasuries return is 1%, a three-times (or 3x) leveraged Treasury fund returns 3%. Similarly, a 3% drop in bond value in a 3X leveraged bond fund produces a 9% loss.

As an example of the inherent risk and volatility of leveraging, consider the action in the ProShares Ultra 20+ Year Treasury ETF (ticker: UBT) in the autumn of 2011. From a closing price of $105.25 on August 31, the fund surged to $140.52 by October 3 and then plunged to $111.38 on October 27 – a loss of 20.7% in just 18 trading days. Before buying a leveraged bond product, assess your risk tolerance to see if you could withstand this type of volatility.

Inverse Bond Funds

Leveraged bond funds aren’t the only leveraged option for fixed-income investors. There are also inverse bond exchange-traded products (ETPs) which bet against the market. Some of these ETPs are two- and three-times leveraged, except they move in the opposite direction of the leverage bonds and purport to represent an opportunity for investors to profit from rising bond rates. However, they present the same risks as other leveraged bonds.

Do Investors Misunderstand Leveraged Bond Funds?

Whatever the original intention of leveraged funds may have been—it is sometimes claimed that were designed only for short-term trading strategies by sophisticated investors—they have become extremely popular among retail investors, who sometimes hold them as long-term investments.

The trend in bond funds toward leveraging and the accompanying use of derivatives to compound returns has alarmed the International Monetary Fund (IMF), which published a position paper in early 2016 on the growing danger. The same paper also noted that it is not only the managers of bond funds that are labeled "leveraged" who employ leveraging. A growing number of supposedly plain-vanilla bond funds also use derivatives. This practice, the IMF noted, presents a hidden risk for ordinary investors.

Investors should also be aware that the two- and three-times leveraged funds only provide the expected performance on single days. Over time, the effect of compounding means that investors won’t see the performance that is exactly two or three times the performance of the underlying bonds. In fact, the longer the time period, the greater the divergence between actual and expected returns. It is another important reason why leveraged funds shouldn’t be considered long-term investments.

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.