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Rooting for Rising Rates: Inverse-Bond Mutual Funds

by Stephen Taub

With the economy continuing to perk up and Federal Reserve chairman Alan Greenspan acknowledging that interest rates could rise in the future, fixed-income investors have been moving into products that don't lose their value much due to rising inflation or rising rates.

While TIPS, Step-up Notes and "I" Bonds have been around for awhile, Inverse bond mutual funds, which actually go up in value if interest rates go up, have been attracting a lot of attention and money lately.

There are currently two such funds. The largest is the Rydex Juno Fund, which currently has more than $1.1 billion in assets, and ProFunds Rising Rates Opportunity fund, which currently has more than $300 million in assets.

Both funds go up when rates go up because they short the long Treasury bond.

With a current duration of 14 years, these funds are structured to go up 14 percent for every one percent point-or 100 basis points-rise in interest rates.

"With the threat of potentially rising interest rates," investors are using it as an interest rate play," points out Anne Ruff, manager of the Rydex Juno fund.

The funds are also being used as downside protection for fixed-income portfolios. She says many investors and investment advisors are taking cash generated by existing fixed-income investments and putting it into Juno, waiting for rates to go up.

The thinking is that once rates do finally rise, a lot of this money will then be switched over to higher-yielding fixed-income investments.

The funds are favorites among active traders as well, who use them to hedge in the bond market.

Strategists who like to ladder bond portfolios also integrate inverse bond funds since during a rising interest rate environment they help offset the declining values of the remaining bonds in the portfolio.

Now, don't expect to receive the full 14 percent if rates jump up a percentage point. This is because, in the case of Rydex Juno, you must subtract 1.41 percent in expenses and the negative cost security.

What's negative cost security? Remember, the fund shorts, or borrows the money to pay for, the long Treasury bond. So, while it is short, it must pay the current yield of 5 percent or so.

To offset this required payout, the fund hedges with two repos that earn about 2 percent in interest.

So, subtract that 5 percent current yield it must pay out and 1.41 percent in expenses, then add back the 2 percent from the repos, and you wind up earning closer to 9.5 percent for every one percentage point rise in the long bond rate.

ProFund's offering is like Juno, but on steroids.

It seeks 125 percent, before fees and expenses, of the inverse of the daily price movement of the most recently issued 30-year U.S. Treasury Bond (the long bond),

To get to 125 percent, it uses leverage in the form of futures contracts and swaps, so its correlation to a 1 percent rise in rates is 1.25 percent.

As a result, its value roughly changes 18 percent for every 1 percent change in yield, before all of the expenses and gains from swaps.

ProFunds' fees, however, are higher than Rydex's fees. The Investor class, which is mostly sold directly to investors, has a 1.94 percent expense ratio while the Service class, sold through investment advisors, has a 2.94 percent expense ratio, which includes a 100 basis points 12b-1 marketing fee. Otherwise, the funds are exactly the same.

And, of course, the ProFunds offerings also must pay the 5 percent coupon on the bond it shorts. But, because of its leverage, the ProFunds portfolios earn 225 basis points from repos versus 200 basis points that Rydex receives because ProFunds uses borrowed money to give it that extra kick when rates rise.

So, if you do the math, for every 1 percent rise in rates, the Investor class would enjoy a roughly 13.25 percent return while the Service class would return roughly 12.5 percent.

The inverse funds are relatively new so they aren't heavily battle tested during rate runups.

But, ProFunds ran some numbers. It points out that in 1999, the last year interest rates rose, the Long Bond lost 12.80 percent as its yield rose by 1.38 percent.

So, if you assume that in 1999 an inverse bond fund sought daily results that were inverse of the Long Bond's daily price movement, the hypothetical fund would have gained 25.47 percent.

Now assume another inverse bond fund existed that sought to magnify the inverse of the Long Bond's daily price movement by 125 percent, like the ProFunds offering. It would have gained 30.81 percent in 1999.

What happens if rates drop?

Keep in mind that both hypothetical funds include accrued interest and exclude annual expenses and would, of course, experience a loss in a falling interest rate environment.

For example, in 1985, a one-year period of falling interest rates, the Long Bond's yield decreased by 2.26 percent--from 11.53 percent to 9.27 percent.

During the same period, the fund benchmarked to the Long Bond gained 36.16 percent, while a fund seeking the inverse lost 15.35 percent, and a fund seeking 125 percent of the inverse lost 20.48 percent.

Another reminder that you should be very familiar with what you're getting involved with.

Stephen Taub is Contributing Editor to BondsOnline. Stephen has been covering financial markets for more than 20 years with Financial World magazine, Individual Investor.com, CFO.com, and others.