Bond Market Selloff Can Be Profitable if You Use the Right ETF

NEW YORK (TheStreet) -- The recent selloff in the Treasury bonds has been so unnerving that many investors have been tempted to join the stampede. But don't flee yet. There are, in fact, several ways to profit from the bond turbulence using exchange-traded funds.

First, let's take a look at what's been happening over the past week. A combination of economic and market factors has made Treasury bonds less appealing to investors. The resulting drop in bond prices has pushed up their yields. The benchmark 10-year Treasury now yields 2.2%, up from 2.05% a week ago and 1.89% in early April.

The more yields rise, the more investors flee. That's dinged some of the largest, most well-known fixed-income ETFs.

For the week that ended May 5, five of the 10 ETFs with the biggest outflows of money were bond funds. For example, the iShares 20+ Year Treasury Bond ETF (TLT) lost nearly $740 million during that week, while investors pulled $1.5 billion from the iShares iBoxx $ High Yield Corporate Bond ETF (HYG), the largest junk bond ETF, according to ETF.com data.

Last month, investors yanked $122 million from high-yield bond ETFs, according to State Street data.

There are several ways to protect yourself and even profit in this market. A traditional approach would be to buy a bearish bond ETF that bets against the market and rises in value when government bond yields rise.

One such ETF is the ProShares UltraShort 20+ Year Treasury (TBT). The bullish side of that bet is the Barclays Capital US Treasury 20+ Year Treasury Bond Index. Both follow the same bond index, but the ProShares ETF gains when yields rise while the Barclays ETF gains when yields fall. The ProShares ETF actually gains twice as much as the Barclays ETF falls. So a 1% drop in the Barclays ETF means a 2% gain in the ProShares fund.

Investors comfortable with more risk should consider the Direxion Daily 20-Year Treasury Bear 3X Shares (TMV). That ETF is not linked to the Barclays U.S. 20+ Year Treasury Bond Index, but it often reflects three times the daily inverse performance of TLT. Over the past month, TLT is off 7.4% while TBT and TMV are up 15.5% and 23.5%, respectively.

Investors who are uncomfortable with leverage have options, too, including embracing negative-duration or zero-duration funds. The ProShares Investment Grade-Interest Rate Hedged ETF (IGHG), which debuted in November, is one such fund. The ProShares Investment Grade-Interest Rate Hedged ETF's portfolio of investment-grade corporate debt and short positions in Treasury notes is designed to deliver a duration of zero, though the fund's current effective duration is -0.18 years, according to issuer data.

Negative-duration funds, such as IGHG, are still relatively new concepts in the ETF industry, but they offer investors significant protection if rates rise. Consider this: A $100,000 bond portfolio with a duration of seven years would lose $7,000 for every 1% increase in interest rates, according to ProShares.

On a combined basis, nearly 40% of IGHG's holdings are rated A- or BBB+ and over 40% carry ratings ranging from A+ to AAA, the highest investment grade. Although its duration is negative, the fund offers investors solid income-generating potential with a 30-day SEC yield of 3.2%.

This article is commentary by an independent contributor. At the time of publication, the author held no positions in the securities mentioned.

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