Our long national "conundrum" may finally be over.
Long-term interest rates are moving up, and the yield curve is at long last steepening. And for the folks who were skeptical of the
rate-hike campaign over the last two years, well, they don't have Alan Greenspan to kick around anymore.
So now that Treasury bonds are at last responding to the Fed's maneuvers, is there a way to make money off of them?
Since January, the yield on the benchmark 10-year Treasury note has jumped from 4.5% to 5%. Phil Roth, technical strategist for Miller Tabak, says yields of 5.5% or even 6% aren't too difficult to imagine by year's end.
"If the Fed stops hiking rates at 5%, then long-term yields should end up decently above short-term rates," says Roth. "That means a yield of 5.5% or more is an entirely reasonable prediction."
Fundamentally speaking, Nathan Rose, a fixed-income trader at the fund family Payden & Rygel, says long-term rates will continue to rise "should the economy merely maintain the blistering pace it set in the first quarter of 2006." Advanced first-quarter gross domestic product numbers will be released later this month, and expectations are for growth of nearly 4.7%.
For fixed-income investors who are convinced that the economy will remain in overdrive and that long-term rates will continue to head north, one option is inverse bond mutual funds. These funds increase in value if interest rates go up, a feat of financial wizardry accomplished by portfolio managers short-selling Treasury bonds.
The two largest funds in this category are the $1.53 billion
Rydex Juno Investor fund and the $414 million
ProFunds Rising Rates Opportunity fund.
The Rydex Juno fund's benchmark is the inverse of the daily price movement of the 30-year U.S. Treasury bond, often referred to as the long bond. If the fund meets its objective, the value of the fund's shares will increase when the price of the long bond decreases. For example, if the price of the long bond goes down by 2% (lifting yields higher, since bond yields move inversely to price), the value of the fund's shares should go up 2% on that day.
The ProFunds Rising Rates Opportunity fund is a souped-up version of the Rydex fund. It employs leverage in the form of futures contracts and swaps -- the exchange of one security for another -- to seek results that produce 125% of the inverse of the price movement of the long bond. Or, put more simply, if the price of the long bond falls 1%, the value of the fund's shares should rise by 1.25% before fees come into play.
Both funds have been on a tear since the start of the year as the long bond has fallen in price. Rydex's fund is up 9.71%, while the ProFunds fund has gained 12.5% year to date.
Morningstar analyst Todd Trubey says the Rydex and ProFunds inverse bond funds offer fantastic returns when interest rates rise sharply, but the difficulty -- and the danger -- is in getting the timing right.
"This is an aggressive bet to make for the average investor," says Trubey. "Professional bond fund managers have been confident that rates would rise for more than two years, and they have been wrong for the majority of the time."
In 2005, the Rydex and ProFunds offerings lost 5% and 7.5%, respectively. In 2004, they lost 8.7% and 10.8% as interest rates refused to budge from basement levels, despite experts' assurances that a stronger economy and spiraling U.S. budget and trade deficits would drive Treasury yields higher.
In all, aside from a few head-fakes, the Rydex fund is down more than 30% since 2000 and the ProFunds fund is down 30% since its introduction in May 2002.
That said, if an investor times his purchase correctly, then these inverse strategies can be quite profitable, as evidenced by this year's impressive returns to date and a run-up in the fall of 2005.
Trubey suggests that investors' best bet is to use these funds as a hedge against large bond portfolios. For example, investors holding laddered bond portfolios, or a group of bonds with a range of maturities, can use inverse bond funds to help neutralize the deteriorating values of the remaining bonds in their portfolio.
A final word of caution concerning these two particular inverse bond funds: They have high fees for what is essentially a fixed-income index fund in reverse.
"Rydex and ProFunds have a history of charging overly high fees for their products," says Max Rottersman, founder of Fundexpenses.com, a Web site that tracks costs in the mutual fund industry. "And many of their offerings are just different ways to gamble and probably should be avoided by individual investors."
Rydex charges an expense ratio of 1.32%, a cost more in line with the Morningstar average for equity funds than bond funds. The expense is more than 50 basis points higher than the average bond fund. The ProFunds fund charges an outsized expense ratio of 1.42%, but then again, it's a fund seeking outsized gains.