Inverse Bond ETNs?

[grumpy]

I am at the point where my net worth is sufficient to meet all foreseeable needs for the rest of my life and to leave substantial assets to my children. I have made a number of changes to my asset allocation to make it more conservative. My intent is to guard against substantial losses even it this markedly limits up-side potential.

Given the current very low interest rate environment on CDs and the potential for large principal loss on bond funds when rates rise, I am looking at inverse bond ETNs such as Barclay's iPath US Treasury 10 Year Bear ETN (DTYS). I am considering replacing a portion of my IRA that is currently invested in the Vanguard Total Stock Market Index fund with such an ETN.

Does anyone here have any experience with these? What questions should I be asking? Opinions and advice welcome.

 

[Onward]

I don't trust ETNs in general and no longer buy them. IMO they make you too dependent on the solvency of a single company (i.e., the issuer).

The owners of Lehman-issued ETNs got creamed.

 

[jon-nyc]

Plus, like most derivatives, they are zero sum. Either the firm that designed and structured them will make money, or you will. But not both. Give that a lot of thought before you buy.
(Though in fairness that's true of any insurance like contract)

Generally these things sound good but are based on really expensive embedded optionality (or really cheap optionality if the note buyer is writing it).

 

[karluk]

Even if you are right about the future direction of the bond market, there's no reason to believe that you will profit by buying and holding DTYS. Take a look at the most recent six month performance of DTYS compared to ten year treasury yields (^TNX). In that time period, ten year t-note yields rose by about 13% at the same time that DTYS declined by about 2%. If you had made your investment in DTYS six months ago, you would have turned out to be 100% correct in your prediction of rising interest rates ahead, but would also have suffered a net loss on the investment designed to cash in on your prediction.

iPath US Treasury 10 Yr Bear ET ETF Chart - Yahoo! Finance

 

[jon-nyc]

(Though in fairness that's true of any insurance like contract)

I want to qualify this. While insurance is 'zero sum' between any one customer and the underwriter, the product as a whole pools risk ergo some customers can make out financially even as the company does.

For these notes, the bank on the other side of the transaction will either make money on every single one of them, or lose money on every single one of them. They know that, and they structured and priced them. Keep that in mind whenever you evaluate a structured note.

 

[Animorph]

I want to qualify this. While insurance is 'zero sum' between any one customer and the underwriter, the product as a whole pools risk ergo some customers can make out financially even as the company does.

For these notes, the bank on the other side of the transaction will either make money on every single one of them, or lose money on every single one of them. They know that, and they structured and priced them. Keep that in mind whenever you evaluate a structured note.

I believe they also sell that risk to other large customers who want it. Barclays may not have a big bet on this particular product, and we may not know who may have to pay up on the other side. Not sure that makes it any better though.

Edited to add: They can also hedge by buying the actual bonds of course. And ETN prices float like any other share. They are not set directly by Barclays.

 

[jon-nyc]

THey most likely hedge immediately upon producing the notes, that's what we did when I worked at one of their competitors. These things have a large positive PV out of the gate for the bank (precisely for the reasons I mentioned) so they book it right away.

 

[FIRE'd@51]

Three points you need to make sure you understand:

As was mentioned above, because it's an ETN (as opposed to an ETF) there is no segregated portfolio backing up your investment should the issuer fail. So you are exposing yourself to the credit risk of the bank that issues the ETN - in this case Barclays.

If you are looking to use DYTS to hedge an existing bond portfolio, you need to understand that you are approximating shorting 10-year Treasuries as a hedge. Since you are short the 10-yr Treasuries, you must pay the interest rate of about 2% per year. Add in the 0.75% expense ratio and you are reducing the yield on your bond portfolio by about 2.75% annually.

The rebalancing can introduce negative tracking error relative to actually being short the underlying index. This effect is present in all inverse products. You want to be sure you understand this effect in order to avoid any surprises later.

 

[grumpy]

Thanks to all who responded. You have pointed out a number of drawbacks to these inverse bond ETNs that I hadn't figured out on my own. I guess I will have to rethink my strategy.

Do you know of any other way that I can reduce the risk of substantial losses in the bond mutual fund portion of my asset allocation when interest rates rise? I already have as high an allocation to equities as I am comfortable with so just shifting from the bond funds to stock funds is not how I want to go.

 

[REWahoo]

Do you know of any other way that I can reduce the risk of substantial losses in the bond mutual fund portion of my asset allocation when interest rates rise?

Be careful you don't end up jumping from what you think will be a frying pan into what may be a fire.

My strategy is to keep the bond portion of my AA in a mix of intermediate and short term funds. I'm focusing on the long view and anticipate any losses in those funds due to rising rates will not be substantial. Even if I'm wrong and they take a haircut, the decline should be of relatively short duration.

No matter the fluctuation in the value of my bond funds, I expect them continue to pay dividends for my cash flow needs. Everything else is background noise.

 

[brewer12345]

Do you know of any other way that I can reduce the risk of substantial losses in the bond mutual fund portion of my asset allocation when interest rates rise? I already have as high an allocation to equities as I am comfortable with so just shifting from the bond funds to stock funds is not how I want to go.

There are lots of ways to skin this cat:

- keep your durations low. All else being equal, the lower your duration the lower your risk.

- shift some money to CDs. Chosen carefully, you should be able to get yields well above treasuries of equivalent maturity and have the option of surrendering early for a de minimus penalty if rates spike.

- buy some insurance. Periodic purchases of puts on something like TLT or IEF will give you some protection if rates spike. This could get expensive over time.

- Diversify elsewhere. I use merger arbitrage funds as a stand-in for some of my fixed income exposure. I own modest amounts of ARBFX and MERFX,

There are other possibilities, but these seem like the most obvious.