ETF Plays for the Bond Game

Mutual fund investors can buy inverse bond funds if they want to make a few bucks from the recent spike in Treasury bond yields. But what about exchange-traded fund investors? What options do they have in a rising rate environment?

The yield on the benchmark 10-year Treasury bond has risen from 4.5% to more than 5% since the start of 2006. As a result, the two largest inverse bond funds, the $1.53 billion ( RYJUX) Rydex Juno Investor fund and the $414 million ( RRPIX) ProFunds Rising Rates Opportunity fund, have jumped 9.7% and 12.5%, respectively.

The trick to these specialty mutual funds is that they increase in value if interest rates go up, a financial feat accomplished by portfolio managers short-selling Treasury bonds.

As of yet, there are no ETFs that provide a similar inverse function, though it may not be long for such an offering, considering the flurry of new ETFs rolling off the assembly line.

Until that day, ETF investors will have to make do with fixed-income trading vehicles that can track fixed-income indices.

If you think bond prices are going to fall (meaning yields will rise), one option would be to simply sell short the most popular fixed income ETF, the Lehman 20+ Treasury ( TLT) fund. The TLT tracks the price and yield performance of the long-term sector of the U.S. Treasury market as defined by the Lehman Brothers 20+ Year Treasury Index.

One of the main advantages of ETFs over mutual funds is the ability to sell them short. In this case, an investor would try to profit by selling the TLT high and buying it back after the spike in yields drives the price down.

Before pulling the trigger, however, investors should note the major risk in shorting the TLT: An economic slowdown could cause interest rates to do an about-face and approach zero. Such an event would cause TLT prices to spike, forcing investors to cover their shorts at a loss.

And don't think it can't happen! Remember that interest rates in Japan -- the world's second-largest economy -- remained stuck at zero for years after the economy went bust in the 1990s.

"There is always the risk that interest rates can go down, especially when you consider that so many people got the direction of rates wrong these past two years," says Lipper senior analyst Don Cassidy, who covers ETFs and closed-end funds. "And remember that you have to pay the interest accruing on the bonds when you short the TLT, it's like being short a stock where you have to pay the dividends out."

In order to limit that risk, ETF aficionados can instead purchase put options on the TLT. Buying options, just as in short-selling, is a benefit of investing in ETFs over typical mutual funds.

"Buying puts is the simplest way to establish a bearish position, or bet that rates will rise, on bonds in that your risk is limited to the cost of the option while the profit potential is unlimited," says Steven Smith, options columnist for TheStreet.com and RealMoney.com. "But it's important to be aware that options are an eroding asset, and therefore you will be facing the headwind of time decay."

In order to combat the time decay problem, Smith suggests investors buy at-the-money put options -- meaning options with a strike price equal to the price where the stock is currently trading -- with at least nine to 12 months remaining until expiration.

Expect the TLT to move 1 point for approximately each 11-basis-point change in the 10-year's yield. So in order to make money on puts, even in a nine- to 12-month time period, rates need to rise swiftly and sharply.

For example, on April 12, with the TLT priced at $85, the January 2007 $85 puts (at the money) were trading at $3, and the 10-year Treasury note was yielding 5%. In order to make money on the puts, the TLT price needs to sink below the break-even price of $82 ($85 minus $3), meaning rates would have to rise to 5.33% before investors started making money. That's not too distant a target, considering that the Fed is expected to raise overnight rates to 5% at their next meeting.

These investment strategies may be more complicated than most, but they could be a useful option for ETF lovers who expect yields to continue to move higher.

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