About Inverse Bond Funds

Inverse bond funds allow investors to profit when bond prices drop due to an increase in bond yields. Most commonly, inverse bond funds will be tied to U.S. Treasury bonds, bills and notes. One of the largest inverse bond funds in the United States is the Rydex Juno Fund (RYJUX). Two other common inverse bond funds are ProFunds Rising Rate Opportunity (RRPIX) and Potomac Funds Contrabond Fund (PCBDX). The funds often offer additional leverage, increasing potential gains and losses.

Considerations

Investors considering an inverse bond fund need to be aware of several factors that can effect their potential profit. First, investing in an inverse bond fund is a timing play. Historically, inverse bond funds make poor long-term investments. The trick is to get in and get out at the right time, namely when longer term interest rates are rising. Second, the funds typically have higher fees and carrying charges than average mutual funds. Inverse bond funds achieve their inverse relationship to the market by selling long-term bonds. The funds must then invest the cash received into short-term (or even overnight) bonds, frequently at a much lower yield than the bonds that were sold. This spread is known as a carrying charge, and can have a negative effect on the potential return.

Misconceptions

Investors often don't understand the inverse relationship between bond prices and yields. The easy way to remember the difference is that when yields go up, prices go down, and vice versa. For example, which bond would you be willing to pay more for, a 10-year bond paying 5 percent or a 10-year bond paying 8 percent? When interest rates rise, investors sell their lower yielding bonds in order to buy higher yielding bonds, causing the price of the original bonds to drop. Conversely, if an investor is holding an 8 percent bond and interest rates drop to 5 percent, his 8 percent bond has increased in value (price).

Warning

Inverse bond funds are extremely volatile and perform poorly in both flat and lower-trending interest rate environments. Due to their leverage and generally higher fee structure, losses can compound very quickly. Also, the cost of entry into an inverse bond fund is considerably higher than other mutual funds. Many have minimum investment amounts of $15,000 and some have minimum investments of $25,000 or more.

Theories/Speculation

For most of the twenty-first Century, the U.S. has been easing interest rates. The theory behind interest rate management is that lower rates spur growth (a positive effect) but, left unchecked, cause inflation (a negative effect). When the Fed determines that inflation is becoming an issue, interest rates are held steady or increased. The Fed even announces its current bias, either toward raising rates or lowering them. Often, a mere conversation with the Fed chairman about interest rates can have an effect on the broader bond market.

Expert Insight

Inverse bond funds are best left to seasoned investors. A mistake in timing can be very costly. The high barriers to entry into inverse bond funds should tell the average investor that he might be better served looking elsewhere. Remember, the Fed only sets short-term interest rates. Long-term rates are determined solely by market factors. Even when the market should do something in reaction to a change in short-term rates, there is no guarantee that it will.