Adjustable Rate Mortgages and Short Treasury ETFs: A Cautionary Look at Hedging Strategies

Whether you are considering using short Treasury ETFs to hedge against interest rate changes on an adjustable rate mortgage (ARM), it is important to understand the potential risks and limitations associated with these financial products. In this article, we explore why short Treasury ETFs may not be the best choice for long-term hedging and discuss alternative strategies.

Understanding Adjustable Rate Mortgages

An adjustable rate mortgage (ARM) is a type of home loan where the interest rate can fluctuate based on market conditions. Borrowers may be concerned about potential increases in their monthly payments, especially as interest rates rise. To mitigate this risk, some investors propose hedging through short-term Treasury ETFs. However, the effectiveness and suitability of this approach require careful consideration.

The Limitations of Short Treasury ETFs for Long-Term Hedging

When considering the use of short Treasury ETFs, it is crucial to understand the mechanics of these financial instruments.

Design Purpose

Short Treasury ETFs, such as ProShares UltraShort products, are designed to offer -200% of the daily performance of the underlying Treasury index. For example, the TBZ ETF aims to deliver a return that is -200% of the short-term Treasury bill index. While this structure might seem appealing for short-term traders, it may not be the best choice for long-term hedging strategies.

Compounding Tracking Error

One of the main concerns with short and inverse ETFs is the compounding tracking error. This error can significantly impact long-term performance, leading to substantial discrepancies between the expected and actual returns. As volatility increases, the tracking error can exacerbate, making short-term ETFs even less reliable as long-term hedging instruments.

For instance, during a period of high volatility, such as the global financial crisis in 2008, an investor using a short ETF expecting -200% of the SP 500 return may experience unexpectedly poor performance. In a scenario where the SP 500 declines by 43.28%, an investor holding a short SP 500 ETF might see a return of only 52.93% instead of the anticipated 86.56%.

Extended Holding Period

When the holding period extends beyond a few months, the compounded tracking error can become even more significant. For example, over a twelve-month period, even if the market declines significantly, the short ETF may still underperform the underlying index.

Consider a situation where the SP 500 declines by 22.53% in a year. While the investor correctly predicted the market movement, the short ETF (TBZ) would likely underperform, resulting in a decline of 29.73%. This highlights the risks associated with relying on short ETFs for long-term hedging.

Alternative Hedging Strategies

Instead of relying on short Treasury ETFs, there are other strategies that may be more suitable for long-term interest rate hedging:

Treasury Futures Contract

One effective method is to use Treasury futures contracts. These contracts offer a more direct way to hedge against interest rate fluctuations, providing a more stable and predictable performance over longer periods. While requiring a certain level of financial sophistication, Treasury futures can provide a more reliable hedge.

Treasury Securities

Another option is to directly buy Treasury securities. Holding government bonds can offer a safer and more consistent income stream than short-term ETFs. Long-term Treasury bonds tend to be less volatile and can provide a predictable yield over extended periods.

Interest Rate Derivatives

Interest rate derivatives such as swaps and options can also be used to manage interest rate risk. These instruments offer a more customized approach to hedging, tailored to individual financial situations and risk profiles.

Conclusion

While short Treasury ETFs like TBZ may seem like a straightforward way to hedge against interest rate changes on an adjustable rate mortgage, they come with significant risks, especially when held over long periods. It is essential to understand the limitations of these products and consider more robust hedging strategies. Consulting with a financial advisor can provide valuable insights and help you make informed decisions.

For further reading and a deeper understanding of the complexities of leveraged and inverse ETFs, we recommend the academic literature by Marco Avellaneda, particularly his work on the path dependence of leveraged ETFs.