The Risks and Rewards of Leveraged Bond Funds

$1000 denomination US Savings Bonds
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In the past, investors looking for excitement certainly weren’t going to find it in the bond market—unless they were trading bond futures and options. Bonds were not regarded by investors as high-returning investments. However, investors can take advantage of an opportunity to invest in bond funds that use leverage to boost their earnings—as long as they accept the high amount of risk involved.

Learn about leveraged bond funds, the risks involved, and how you can use these funds to your advantage.

Key Takeaways

  • Leveraged bond funds attempt to increase their returns by using borrowed money or derivatives to multiply investment returns.
  • A three-times leveraged bond fund has the potential to triple gains…or triple losses.
  • Inverse bond exchange-traded products (ETPs), which bet against the market, are another leveraged option for fixed-income investors.
  • Investors should be aware that two- and three-times leveraged funds only provide the expected performance on single days.

What Is a Leveraged Bond Fund?

In financial terms, leverage is the use of debt to finance operations or investments. Concerning bond funds, leverage refers to using debt to purchase the bonds, then create issues within a fund for investors to buy.

Risks and rewards to investors depend upon how well the underlying bonds in the fund perform.

How Do Leveraged Bond Funds Work?

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 attempt to increase their returns by using borrowed money or derivatives to multiply investment returns.

For example, a three-times leveraged bond fund with $100M in assets from its investors may borrow another $200M against shareholder capital. The fund managers use those borrowed funds to purchase more bonds on behalf of its investors to triple their gains. However, this also has the potential to triple their losses.

Before buying a leveraged bond product, assess your risk tolerance to see if you could withstand the amount of volatility leveraged funds have.

Additionally, consider if a Treasury Note's return was 1%—a three-times (3x) leveraged Treasury fund would return 3%. Similarly, a 3% drop in bond value in a 3x leveraged bond fund would produce a 9% loss.

The inherent risk and volatility of leveraging can be demonstrated by considering the action in the ProShares Ultra 20+ Year Treasury ETF (UBT) in the autumn of 2011.

From a closing price of $26.31 on August 31, the fund surged to $35.13 by October 3 and then plunged to $27.84 on October 27—a loss of 20.7% in just 18 trading days.

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) that bet against the market.

Inverse bond funds may be more risky than most investors can handle.

Some of these ETPs are two- and three-times leveraged, except they move in the opposite direction of the leveraged 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.

What Are the Risks of Leveraged Bond Funds?

Since leveraged funds use debt to finance their underlying assets, any downward trend in the bonds within the fund will amplify losses when held as long-term investments. The risk lies with the fact that someone will need to pay the loans off if the fund defaults. Investors inherit that responsibility when they invest in the fund.

Swaps, options and other derivatives tend to influence bond fund performance. Derivatives of any investment are generally riskier than the investment they follow. If a leveraged bond fund allows derivatives, the fund's investors inherit that additional risk along with leverage risk.

Leveraged bond fund derivatives create hidden risk for ordinary investors because they might think they've invested in a bond fund when in truth, they are invested in a mixed-bond and bond derivative fund.

Leveraged bond funds shouldn't be considered long-term investments. Bonds themselves are subject to inflation risk over the long term—and if the fund goes under, there can be massive amounts of debt to be collected.

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 precisely two or three times the performance of the underlying bonds.

In fact, the longer the period, the greater the divergence between actual and expected returns. It is another crucial reason why leveraged funds shouldn’t be considered long-term investments.