How to Short the U.S. Government

With the threat of a bond market crash on the horizon, a series of new products promise to turn a profit by selling short Treasury bonds. But not all of them deliver for buy-and-hold investors – and some of may perform no better than the bond indexes they're supposed to short.

Last week, ProShares launched a new exchange-traded fund that lets investors short Treasury inflation-protected securities, or TIPS – the ninth such exchange-traded product to debut since 2008. Already investors have put more than $7.3 billion into funds that short U.S. government bonds. Since January 2010, two have more than doubled in size and one has more than tripled. And the iPath Treasury 10-Year Bear ETN ( DTYS: 55.36, -0.30, -0.53% ) , launched last August, is now 22 times the size it was six months ago.
The growing popularity of these funds is easy to understand. They basically allow investors to bet that interest rates will rise, causing bond prices to fall, says Robert Whitelaw, the chair of the finance department at New York University's Stern School of Business. Today's low rates and the prospect of future growth and inflation make rising rates likely, says Bret Barker, a fixed income specialist at TCW. Some investors may also have concerns about the country's high debt level, Barker says: Treasury prices would fall if investors around the world starting dumping Treasurys on worries about the U.S.'s ability to pay off its debt, just as prices on Greek and Irish debt fell last year.

But investors who buy these arguments shouldn't necessarily buy inverse Treasury ETFs. Most of the products are designed to give investors the inverse of the daily performance of a benchmark long Treasury index. The key word is daily: That means that returns are compounded every day. Over a month you don't get the negative of the total monthly return, but the compounded version of negative daily returns, says Whitelaw. "They're actually not the same thing." As a result, an ETF that tracks the Barclays Capital U.S. 20+ Year Treasury Bond Index ( TLT: 89.92, +0.40, +0.44% ) is down 5.27% since August 2009, while the inverse product that tracks the same index has fallen 6.16%.

The problem with compounding, mathematically, is that a loss always has a bigger impact than a gain, says John Gabriel, an ETF strategist at Morningstar. If you have $100 in an investment that gains 10% one day, you now have $110. Lose 10% the next day, and you're not even – you're in the hole, down to $99.

Add leverage, as many of these products do, and the "volatility drag" from daily compounding bites even harder, Gabriel says. Take our hypothetical $100 investment that gains 10% and then loses 10% - a two-times leveraged product would end those two days at $96 (up 20% to $120, then down 20% of that, which is $24). The real-world results prove the point: Since the Direxion Daily 20 Year Plus Treasury Bear 3x Shares ETF was launched in April 2009, the ETF that tracks long-duration Treasuries is down 13.24%, but its leveraged inverse twin is down 20.05%. That's not tracking error – these ETFs are delivering exactly the results they're designed to. "The problem with inverse ETFs is not that they're bad, it's that they don't give people exactly what they think they're getting," Whitelaw says.

Investors using these products do need to make sure they understand how they work, says Andy O'Rourke, Direxion's chief marketing officer. Because they have a daily performance goal, investors should watch their performance daily, O'Rourke says. "Volatile periods will hurt the expected performance, but if we see a period where interest rates start rising slowly but steadily, that's going to be fortuitous for a leveraged fund. If it is a steady trend, you'll actually see the performance be more than 3 times the index's return," he says.

For buy-and-hold investors, the lesser-known exchange-traded notes are actually a better solution, Gabriel says. Instead of rebalancing daily, these products provide investors with returns calculated at maturity or redemption, at a rate of 10 cents per one-point move in the underlying index. For November through January, for example, the Barclays Capital Long Bond US Treasury Futures Targeted Exposure Index is down 12.72% and the iPath US Treasury Long Bond Bear ETN ( DLBS: 55.39, -0.09, -0.16% ) is up 13.89%. Because of their different design, this and the other two iPath ETNs that short Treasuries ( DTYS ( DTYS: 55.36, -0.30, -0.53% ) and DTUS ( DTUS: 51.09, -0.17, -0.33% ) ) could comfortably be held for longer periods, Gabriel says.

Alternatively, investors could seek out a variety of assets that do well in periods of growth and inflation, including stocks , Mahn says. Unless an investor has a strong conviction about a very short-term move in Treasurys, "the longer-term view is just not to own them, period, and to own other assets," Barker says.



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