Because ETFs allow investors to buy into entities beyond the stock market while staying on a stock exchange, it is tempting for investors to jump into exotic markets like futures. Here we’ll briefly introduce you to two types of exotic ETFs, and the potential benefits and pitfalls of investing in them.
An Introduction to Bond ETFs
There are a number of ETFs that bet on changes in the interest rates, with varying structures and methods. One of the most popular ways to bet on a rising or falling interest rate is to buy ETFs that try to track the government bond market, like the iShares Barclays 20+ Year Treasury ETF (TLT) or the ProShares Short 20+ Year Treasury ETF (TBF), which is the inverse version of TLT.
Fund managers of these and other interest-rate ETFs will use a variety of positions in the bond and debt market to reflect changes in the interest rates that are set by central banks. This change of interest rates, known as monetary policy, is usually initiated by a central bank to maintain low unemployment and relatively stable prices on goods. While it is debatable how effective these policies are, central banks use their influence on interest rates to stimulate the economy when times are bad, and to cool down an economy that might be heating up too quickly, causing it to become unstable.
Bond funds are a way to bet on a Central Bank’s change in monetary policy. If you expect the economy to fall and be faced with the possibility of recession, depression, or deflation, then demand for bonds will rise, causing funds like TLT to go up. (Take a look at TLT’s performance at the end of 2008 and beginning of 2009 to see how much bonds can go up in times of crisis).
Bonds and Hedging
While the bond market does not always go up when the stock market goes down and vice versa, they often do, so bond ETFs are a good way to hedge your bets when playing the stock market. In theory, a portfolio manager will buy bond ETFs or bonds directly to mitigate the exposure to the risks that a change in interest rate will hit the stock market and cause the value of his or her stocks to fall.
Short-Term versus Long-Term Bond ETFs
While there are several bond ETFs out there, almost all of them specialize in short-term or long-term bonds. It is important to remember that short-term interest rates are immediately tied to the Federal Funds Target Rate, which is the rate that all banks lend to one another, as mandated by the Federal Reserve. In other countries the same concept applies, but the nomenclature is different.
When the Federal Reserve sets the FFTR, short-term bonds will effectively be set at the same rate. Longer bond rates will go up or down according to market sentiment, which is largely influenced by the short-term rate as well as the Federal government’s credit rating, belief that the market is rising or falling, and a sense of how monetary policy is going to change in the future. Periods of growth and inflation usually mean higher interest rates across the board, and periods of contraction usually mean lower interest rates.
Changes in interest rates are set by basis points (1000 basis points are in a percent change). When describing interest rate risk in a portfolio or financial interest, investors will discuss that interest’s dollar value per basis point, or DV01.
Bond ETFs that specialize in short-term or long-term bonds can thus be used to make bets on the spread between short-term and long-term bond rates, and can be used to hedge larger bets or as a direct investment in the belief that inflation is going to cause long-term bond rates to rise higher than the Federal Reserve can change short-term bond rates, or that deflation is going to push long-term bond rates lower.
Duration and Convexity
Duration refers to the measure of how long cash will flow in relation to a bond. Longer durations mean higher exposure to interest rates. The rate on a bond is inversely proportional to the demand for bonds. Rising interest rates will cause bond prices to fall, while declining rates will cause bond prices to rise. The bigger the duration, the bigger the interest-rate risk/reward for the investor.
Convexity refers to the sensitivity of a bond to changes in interest rates. Since convexity measures this sensitivity, when bond prices become more sensitive to decreasing interest rates, their convexity rises as well. The concept of convexity extends to several other financial instruments, and it is essential for bond investors to understand how quickly and by how much bond values will change as interest rates change. Different analysts will come to different conclusions about a bond’s convexity, depending on what they are looking at and how they see a variety of market conditions, including sentiment, unemployment, Federal Reserve policy, GDP growth, volume in equity markets, and so on.