By Thomas Kenny. Bonds Expert
Leveraged Bond Funds: High Return Potential, But High Risk
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These products, which trade freely on stock exchanges just like shares in individual companies, are investment vehicles that allow experienced investors to achieve daily returns two or three times that of a particular asset class. For instance, if U.S. Treasuries return 1% in a given day, a three-times (or 3x) leveraged Treasury fund would return 3%. These investments are extremely volatile, as you might expect, so they are designed for only the most sophisticated traders, rather than longer-term investors.
Exchange-traded products can take the form of either exchange-traded funds (ETFs) or exchange-traded notes (ETNs). The difference between the two is explained here .
Risks of Leveraged Bond Funds
The main risks of leveraged funds is that they are extremely volatile. If you’re not used to trading fast-moving securities, these securities aren’t for you. As an example, consider the action in the ProShares Ultra 20+ Year Treasury ETF (ticker:UBT) in the autumn of 2011. From a closing price of $105.25 on August 31, the fund surged to $140.52 by October 3, and then plunged to $111.38 on October 27 – a loss of 20.7% in just 18 trading days.
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Before buying such a product – and in particular one of the leveraged products – it’s essential to assess your risk tolerance to see if you could withstand this type of volatility, and make sure you understand that inverse funds are designed to be short-term trading vehicles.
Investors also should be aware that the two- and three-times inverse funds only provide the expected inverse performance
on single days. Over time, the effect of compounding means that investors won’t see performance that is exactly two or three times the opposite of the index. In fact, the longer the time period, the greater the divergence between actual and expected returns. This is the most important reason why the leveraged funds shouldn’t be considered long-term investments.
Inverse Bond Funds
Leveraged bond funds aren’t the only leveraged option for fixed-income investors. There are also inverse bond ETPs, which bet against the market and provide experienced investors with a way to express a negative view on bonds. Some of the ETPs are two- and three-times leveraged, except they move in the opposite direction of the exchange-traded portfolios discussed here. However, they are similar in that they face the same tracking problems as leveraged portfolios.
What are Investors’ Options?
The list of leveraged ETPs is below. Investors have the option to make leveraged bets on U.S. Treasuries, investment-grade corporate and high yield bonds, and the bond market of certain overseas countries:
- Direxion 10-Year Treasury Bull 3X - Triple-Leveraged ETF (TYD)
- Direxion 30-Year Treasury Bull 3X - Triple-Leveraged ETF (TMF)
- PowerShares DB 3x Long 25+ Year Treasury Bond ETN (LBND)
- iPath US Treasury Long Bond Bull ETN (DLBL)
- ProShares Ultra 20+ Year Treasury ETF (UBT)
- ProShares Ultra 7-10 Year Treasury ETF (UST)
- ProShares Ultra Investment Grade Corporate (IGU)
- ProShares Ultra High Yield (UJB)
- PowerShares DB 3x Italian Treasury Bond Futures Exchange Traded Notes (ITLT)
- PowerShares DB 3x German Bund Futures Exchange Traded Notes (BUNT)
- PowerShares DB 3x Japanese Govt Bond Futures Exchange Traded Notes (JGBT)