Two New Ways to Hedge Against Rising Rates

Last week, ProShares launched the Ultra Short Lehman 7-10 Year Treasury ETFPST and the Ultra Short Lehman 20+ Year Treasury ETFTBT -- the first ETFs that allow for shorting the bond market.

From a big-picture view, an investor who thought interest rates were going up could capitalize on that belief with either of these funds.

PST or TBT can be integrated into a fixed-income portfolio as a hedge for rates going higher, but, unlike put options, both funds will pay a little interest. If rates do move up, so will the interest paid by the funds. If rates on T-bills go up, PST and TBT will have a larger payout.

(If you are new to the ProShares line of funds, you should know that the word "ultra" in the name means that the funds are leveraged 2 to 1.)

PST attempts to capture twice the inverse of the iShares Lehman 7-10 Year Treasury ETFIEF, and TBT attempts to capture twice the inverse of the iShares Lehman 20+ Year ETFTLT. So if TLT goes up by 1% on a given day, TBT would be expected to go down 2% on that day.

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Both PST and TBT have the objective of twice the inverse of their base funds on a daily basis. But over a longer period, they may or may not come close to twice the inverse. The longer-term result is really luck of the draw that depends on the combination of up and down days in the future.

That's in line with the behavior of other ultra funds, some of which are near twice the inverse over time, some of which are not.

For example the Ultra Short S&P 500 ETFSDS comes pretty close to twice the inverse over time. However, Ultra S&P 500 ETFSSO, the long version, has not come anywhere close to twice the return over longer periods of time.

Like most of the other ultra funds, PST and TBT will own mostly U.S. T-bills that will generate interest payments to fund holders. Those T-bills will collateralize futures and swaps contracts that create the intended effect, and the funds will charge a 0.95% expense fee.

Interest rates are very low historically, and it seems reasonable that the middle and far end of the curve will go up. Most of the fixed-income market is expensive; of course it could stay expensive for a long time.

I am optimistic that the PST and TBT will not end up looking like SSO, because what they track is less volatile. Ultra products track an index once each day. If the underlying index is very volatile from day-to-day like equities, which were especially volatile over the last few months, then there is greater risk of the result looking like SSO (this is due to the daily resetting process, so that no matter what happened yesterday, the fund had a chance to capture the objective today). With a product that is less volatile, it becomes easier to work as a longer-term hedge because the daily resets are smaller.

The basis for my optimism on this point comes from the performance of the Rydex Inverse Government Long Bond Strategy FundRYJUX. The magnitude has not been quite right, but it has captured the effect directionally.

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