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.
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):
Risks and Benefits of Inverse Bond ETFs
There is one primary risk and one primary benefit of investing in inverse bond ETFs.
Unpredictable Market
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 periods of growth, the Federal Reserve Board of Governors may raise rates to help fight inflation. When interest rates rise, bond prices generally fall. The reason bond prices fall in a rising interest rate environment is 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.
