It is conventional wisdom that typical bond funds or plain-vanilla government issues rise in price when interest rates decline and fall in price when rates rise. But a new retail-level bearish bond fund based on the bellwether 10-year Canada bond does exactly the opposite.

Horizons BetaPro Canadian Bond Bear Plus Fund is designed to be a hedge on upward interest rate moves — a process that is currently underway. Although ordinary bond funds will show losses when rates rise, BetaPro’s $3-million bearish fund generates gains. So, on March 6, when the market anticipated the March 7 Bank of Canada quarter-point interest rate increase to 3.75%, the fund gained 7¢ a unit, rising to $9.88 from $9.81. The following day, when the rate rise was priced into bond fund values, the median Canadian bond portfolio dropped 2¢ to $29 a unit from $29.02 .

The fund — which was launched on Oct. 21, 2005, just as the Bank of Canada was raising short-term rates — is structured to be either an aggressive speculation on rate rises or an efficient hedge against them. It does that with leverage, to provide a 200% return for any decline in the performance of the 10-year Canada bond and, conversely, to lose 200% on any increase in the price of the 10-year Canada bond on any particular day, says Adam Felesky, president of Horizons BetaPro Management Inc. , the fund’s Toronto-based vendor.

Felesky believes the time is ripe for bearish bond funds — and the trend supports him. The Bank of Canada raised its key lending rate for the fifth time in a row on March 7 and hinted that more rate hikes may be on the way.

In addition, the BetaPro fund structure is relatively user-friendly. The A (advisor) version has a management expense ratio of 2.5% when it is bought off the rack, whereas the F (wrap account) version has an MER of 2%.

There are potentially less expensive ways to hedge interest rate moves, but they have drawbacks. You can trade bond futures on commodity markets, but when shorting bonds, the potential for loss is unbounded, Felesky notes. You can also do bond swaps; however, he adds, this method is unavailable for the average retail investor.

But even though the BetaPro fund is a costlier investment, there are several factors that make it attractive: it has a relatively small entry investment level of $5,000; it provides daily settlement; it has visible pricing, like any mutual fund; it has good trading liquidity. It’s even RRSP-eligible, Felesky adds.

Although the mechanics of the bearish bond fund are complex, at its heart is the short-selling of bonds, Felesky says: “Each day, we choose to use a swap or a future. Futures are cheaper, but the correlations to interest rate moves are not as tight as with swaps. We come up with a balance between correlations and cost.”

From an investor’s point of view, what matters is the bond fund’s efficiency. The fund’s single asset, the 10-year Canada bond, presently has a duration — equivalent to the beta for stocks — of seven. That means for every 1% move in interest rates, the 10-year Canada bond will move by 7%. But because the fund has 200% leverage, the 1% move in rates should result in a 14% move in the fund’s value.

So, the leverage means that for every $1 investors put into the fund, they get double the bond’s value as a hedge; or, if they prefer to use the fund as a speculation, then double the exposure to changes in the value of the 10-year Canada bond.

Some advisors like what they see in the BetaPro fund. “For a basket of individual bonds, the fund can reduce portfolio volatility,” says Dwight Mann, an investment advisor with National Bank Financial Ltd. in Vancouver. “It makes taxable accounts more efficient because the client can hold a position with large gains but cover the downside risk by buying the bear fund as a hedge. If rates rise and the bonds in his portfolio fall in price, the hedge rises. It’s a way to lock in gains.”

The fund has been performing well so far. From the Oct. 21 inception date to Feb. 28, the 10-year Canada bond generated a total return of 0.7%, while the BetaPro fund rose in value by 1.4%. “Intuitively, you would think the fund would have lost money,” Felesky says. “But interest accrued on the fund’s investments have more than offset that loss.”

@page_break@Borrowing short

The fund’s returns have been boosted by the difference in return from interest accrued on its short sales and interest accrued on capital invested. The fund is able to borrow short and sell the 10-year Canada bond. The difference in interest accrued and income owed on the short sale is producing a positive 2.8% yield. The fund’s MER can therefore be seen as being reduced by the return to a gain of 0.8% for the F units or 0.3% for the A units.

If one disregards the effects of movement in the price of the underlying 10-year Canada bond, the fund has a negative cost— that is, a positive return. And that should continue as long the yield curve remains relatively flat, Felesky notes.

For retail investors and advisors who want to diversify what may be fairly small bond portfolios, the BetaPro fund has sophisticated attributes. Not only is it cost-efficient for small accounts that advisors want to hedge, but it provides what amounts to time diversification.

Whereas an investor can get some rate hedging by buying a ladder of bonds that spreads interest rate risk over the time span of the ladder, that can involve many trades — and a good deal of management.

The BetaPro fund, on the other hand, is a one-trade investment that isolates the risks of adverse moves on the bellwether Canada bond and thus provides the rate buffer that a ladder or other hedging techniques could achieve. And that effectively diversifies the time risk of owning the 10-year Canada, says Fred Bruun, an investment advisor and certified financial planner with MGI Securities Inc. in Toronto.

Horizons BetaPro Management has also designed a bullish bond fund to provide leveraged exposure to falling interest rates. So far, that fund is on the drawing board, although securities regulators have received a prospectus. “We’ll launch the bull fund when there is sufficient interest from investors. That should happen within the next few months. Then we will have two bond funds, both with 2:1 leverage, that are mirrors of one another,” says Felesky. IE