Timing Critical With Leveraged Bond ETFs

It's difficult to buy and hold these funds, therefore investors must be attentive to timing their purchases during Treasury market rallies.
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The

iShares Barclays 20+ Year Treasury Bond

(TLT) - Get Report

exchange-traded fund tumbled more than 3% on Monday. An investor who purchased the bonds on Friday would have watched 75% of this year's anticipated interest payment negated over the course of a couple hours. Between Dec. 30, 2008, when TLT peaked at $123, and the 2009 low on May 27, TLT lost 24.9%, or roughly nine years worth of compounded interest payments from the peak.

Longer-dated bonds are more sensitive to interest rates because their cash flow is further into the future. This presents greater risk for investors, but also greater opportunity.

Conservative investors interested in protecting principal should restrict their investment in long bonds to an asset-allocation strategy, which will automatically cause them to purchase long bonds when rates are high or near their peak, and bond prices are low, and sell long bonds when the rates are low, and prices are high.

For more aggressive investors, the most difficult things to determine are whether we sit at a peak or a valley and the time remaining until trend exhaustion. Japan, for instance, underwent a multi-decade deflation that kept interest rates low for more than a decade. If long-bond yields decline again and stay low for the better part of a decade, holders of 30-year Treasuries may have the last laugh. Deflation, or at least a weak economy, could keep interest rates within the trading range of the 2000s, limiting the downside from here to about 10% (TLT's low over the past five years was in the low $80s), ignoring interest payments.

On the plus side, rates could fall and prices could return to or even exceed their previous peak and deliver greater than 30%. Evidence still points in favor of deflation in the near term as well. The

Federal Reserve

has expanded its balance sheet, but the money sits on the balance sheets of banks. An ongoing economic crisis will reduce the demand and supply of credit, and the Fed will be powerless to stop it.

On the other hand, there is mounting evidence that the Federal Reserve will be unable to suppress interest rates without the help of a global depression. Last Wednesday, long Treasury yields spiked in the midst of heavy borrowing over three days, to the tune of $100 billion, by the U.S. government. In the midst of a global panic the government found buyers, but it becomes increasingly difficult in a recovery, and the recovery doesn't have to be led by the United States. Should foreign economies recover and increase the demand for raw materials, the cost-of-living indexes in the U.S. will reflect the price changes, workers will demand higher wages, and stagflation could return.

The Federal Reserve holds a trump card since it can "print" money and buy an unlimited amount of Treasury bonds. But this is still limited by market forces. It is fallacious reasoning to attribute god-like powers to actors in the marketplace, even ones in control of a printing press. No matter how great their power, they cannot undo the law of supply and demand; only defy it for a fleeting moment.

As evidenced by the recent spike in yields, Federal Reserve interventions may mark a buying climax as investors unload their Treasuries to the government. Without investor demand for government debt, the Federal Reserve becomes the only buyer at inflated levels and rates remain low only so long as the Fed continually expands the money supply and simultaneously annihilating the U.S. dollar. The currency and precious metals markets always stand ready to enforce monetary discipline on that score as well.

With the Fed in a box, the driver of events will be the market and its reaction to the U.S. government deficits. Eventually, the economy will recover and credit will flow out of the banking system and into riskier investments. Should they flow into commodity investments necessitated by emerging market growth, consumer price index numbers will increase even if the Fed controls credit growth. Foreign government debt will be more attractive than U.S. government debt, let alone the myriad of riskier assets available to investors. In order to stem the flow of capital out of the U.S., higher interest rates will be necessary.

Luckily, ProShares offers a way to bet on higher interest rates: the

ProShares UltraShort 20+ Year Treasury

(TBT) - Get Report

exchange-traded fund, which offers twice the daily inverse of the index behind TLT. As with other leveraged ETFs, however, there is substantial risk. From Nov. 13 through Dec. 19, 2008, TBT lost 43% of its value, and an investor on that date would still be down close to 10%, even though TLT also has declined. This is because of the daily compounding of the returns.

Direxion also offers a triple-short ETF,

Direxion Daily 30-Year Treasury Bear 3x Shares

(TMV) - Get Report

, that tracks the New York Stock Exchange Current 30-Year Treasury Index. But if TBT is risky, this fund could be hazardous to your health. Between April 20 and May 27, 2009, TBT gained 27%, while TMV climbed 55%, or roughly double. Should we witness another Treasury rally such as the one seen last fall, investors in TMV might lose 70% or more of their investment.

The market offers a way to profit from falling bond prices, but the leveraged nature of these ETFs means timing is critical. Although one can never truly buy and hold funds such as these, a more orderly market could make for a smooth ride to higher interest rates. Unfortunately, the current market is anything but orderly. Violent swings are the rule, and an inattentive investor could lose big even if he is right about the overall trend. Investors need to actively trade these ETFs, or time their purchases during Treasury market rallies.

Don Dion is the publisher of the Fidelity Independent Adviser family of newsletters, which provides to a broad range of investors his commentary on the financial markets, with a specific emphasis on mutual funds and exchange-traded funds. With more than 100,000 subscribers in the U.S. and 29 other countries, Fidelity Independent Adviser publishes six monthly newsletters and three weekly newsletters. Its flagship publication, Fidelity Independent Adviser, has been published monthly for 11 years and reaches 40,000 subscribers. Dion is also president and founder of Dion Money Management, a fee-based investment advisory firm to affluent individuals, families and nonprofit organizations, where he is responsible for setting investment policy, creating custom portfolios and overseeing the performance of client accounts. Founded in 1996 and based in Williamstown, Mass., Dion Money Management manages assets for clients in 49 states and 11 countries. Dion is a licensed attorney in Massachusetts and Maine and has more than 25 years experience working in the financial markets, having founded and run two publicly traded companies before establishing Dion Money Management.