How Treasuries and ETFs Work

I have become so comfortable writing about Treasuries and the dollar recently, I have forgotten that not everyone is as intimate as I am with some of the terms and abstract thoughts I use. In the last week, however, I've been inundated by requests from people asking me to explain some of these concepts in more detail, so I have decided to periodically highlight questions from readers and try to expand on that particular idea. If you would like me to clarify something, please don't hesitate to leave a comment, or write to me at questions@pacoahlgren.com.

A few days ago, a reader contacted me regarding TBT -- which is the ProShares Ultra short long-term Treasuries EFT. Michael asks:

"How come the TBT is only up 22% YTD, while the 30-Year Bond's Yield has increased 31%? Moreover, ProFunds has a Mutual Fund (RRPIX) that is supposed to be 1.25X leveraged to the 30-Year, and that Fund is only up 18%!"

This is a fairly common problem people have when analyzing exchange traded funds – especially those that are leveraged like TBT. And while this particular conundrum can entail some complex math, I'm going to try to offer a simple, general explanation.

Before we get started, it's important to note that bond prices move inversely to bond yields – that is to say, when bond prices go up, their yields go down, and vice versa. Most confusion stems from the fact that change in yield does not correspond exactly to change in price. Here's something from an article at leftbusinessobserver.com that illustrates my point:

"Say the U.S. government sells Treasury bonds when prevailing market interest rates are 8%. So, a bond with a face value of $1,000 on issue would pay $80 a year in interest - usually in two half-yearly installments of $40. But if market interest rates were to rise to 10%, then who would want to buy such a bond? So, the market price of the bond would have to fall to a level where that fixed $80 annual payment were the equivalent of a 10% annual yield - in this case, the price would have to fall to $800, so that the annual $80 payment would equal 10% of the purchase price of the bond. (Obviously, this matters only if the holder of the bond wants to sell it in the open market; if he or she wants to keep the bond to maturity, the price fluctuations exist only on paper.) Since bond prices are usually expressed at a percent of face (or "par") value, the price of the bond would be quoted at 80."

In this example, the bond's yield increased 25%, but the bond's price fell only 20% -- due to the fact that correlation between yield and price movements isn't absolute. If you look at it from that perspective and you're willing to do a little research, you should be able to figure out the way it works. Here's a page at learningmarkets.com that teaches how to calculate a bond's yield, given various inputs. That should be a good place to start!

Another thing you need to remember is that TBT is designed to approximate, inversely, the changes in prices (not yields) of longer-term Treasuries -- with maturities of 20 years or more. Also remember that the change in TBT is designed to achieve twice that of the change in the underlying bonds – again, inversely. If you take the time to calculate an average price-change of long-term Treasuries over a given period, and you compare that average to the inverse price-change of TBT (multiplied by two), they should roughly mimic each other.

There are other considerations: changes in the publicly-traded market price of TBT (or any ETF) differ slightly from in-house, managed changes in the securities' net asset value (NAV) -- although the two prices do move very closely. In order to maintain an appropriate NAV, however, ProShares must react to changes in markets and manually maintain their positions. In other words, the change in NAV isn't automatic, and while the managers undoubtedly try to mimic their targets as accurately as possible, none of this is an exact science. Finally, don't forget that ProShares charges a management fee.

I hope this helps!

 

Disclosures: Paco is long gold, DXO, and UCD. He holds no TBT. Paco has been a financial analyst and a portfolio manager for 18 years. You can buy his novel Discipline wherever books are sold. Or visit www.disciplinebook.com. If you have any thoughts or questions, please leave a comment or write to Paco at questions@pacoahlgren.com. While he can't guarantee he'll get back to everyone, he will do his best! Copyright 2009, Paco Ahlgren. All Rights Reserved.