If you think easy money and staggering deficits will lead to inflation, consider investing in an inverse bond fund. By Manuel Schiffres, Executive Editor January 30, 2009 Bond investors are finally coming to their senses. How else to explain the recent run-up in Treasury-bond yields? Since the yield on the ten-year Treasury note bottomed at a record low 2.04% on December 18, it has rebounded to 2.80%. The yield on the 30-year T-bond, which also bottomed on December 18, at 2.54%, closed January 29 at 3.56%. Because bond prices move inversely with yields, the recent moves are bad news for holders of Treasury bonds and funds that that invest in Treasuries. For example, between December 18 and January 29, the share price of Vanguard Long-Term U.S. Treasury (symbol VUSUX) declined by nearly 9%. But what's pain for some is opportunity for others. And thanks to the mutual fund industry, it's now easier than ever for the average investor to bet against Uncle Sam's IOUs. Specifically, there are four traditional funds and two exchange-traded funds that are designed to appreciate when Treasury prices are falling and their yields are rising. Before identifying these inverse bond funds, it's worth reviewing why yields fell so low in the first place and why I think Treasury yields are likely to keep going up-if not immediately, then certainly over the next year and beyond. Advertisement Inflation ahead. Treasury yields plummeted last year for two reasons. First, with stocks, commodities and other kinds of bonds plunging in value, jittery investors sold everything perceived to carry risk and poured the proceeds into presumably safe Treasuries. Second, as the economy tanked along with markets, concerns about inflation quickly dissipated, and investors began to worry about the prospects for deflation. Treasury bonds would be major beneficiaries of deflation because their interest payments, however meager, would become more valuable as consumer prices fell. Plus, no matter how severe our economic woes, Uncle Sam would be able to repay his debts in a timely manner. It's true that there's a whiff of deflation in the air. Thanks in large measure to sagging oil prices, consumer prices in the U.S. fell at an annualized rate of 12.7% in the fourth quarter of 2008. But that's history. In my view, actions being taken now by countries around the world are sowing the seeds for a resurgence of inflation. For starters, governments are enacting massive economic-stimulus programs (prime example: the $819-billion package passed by the House of Representatives on January 27). Advertisement Meanwhile, the Federal Reserve has slashed the short-term interest rate it controls to zero. The Fed is apparently making credit available to all comers and is flooding the economy with money. Throw in the likelihood that oil prices will rise once global economies bottom (falling energy prices are a major reason for deflation worries), and you have the ingredients for higher inflation in the not-so-distant future. And let's factor in the ballooning federal deficit, which is now expected to hit $1.2 trillion in the current fiscal year and is likely to remain in 13 digits for the foreseeable future. We can argue until our faces turn blue about the impact of budget deficits on interest rates. But there's no arguing that deficits of this magnitude mean that Uncle Sam will have to sell more Treasury bonds. That means the supply of bonds will rise, which can't be good for bond prices. There's also the matter of whether foreign nations such as China and Saudi Arabia (both of which already hold gobs of Treasury bonds) will continue to buy our government's IOUs in the face of endless deficits and printing presses churning out dollars at full speed. Six ways to play. One way to deal with higher inflation is to buy Treasury inflation-protected securities (see Time for TIPS). But if you want to bet more aggressively, you can invest in a fund that's designed to go up in price when prices of Treasury bonds fall. Advertisement You need to know two important things about these funds. First -- and this may already be obvious to you -- they will suffer if I'm way off base and interest rates fall, causing Treasury prices to rise. It's also important to note that these funds strive to match the inverse of their benchmarks only on a daily basis. That means that over a longer period of time, a fund's results may not -- in fact, probably won't -- track the fund's index particularly closely (for more on the risks of inverse and leveraged ETFs, read this cautionary piece from Morningstar). Nevertheless, if you're wary of inflation and don't mind monitoring these funds closely, you have a number to choose from. The first four listed below are regular open-end funds; the last two are ETFs. At the end of each section, we list performance during a period of generally rising Treasury bond prices (from June 13, 2008, through December 18, 2008) and a period of generally falling Treasury prices (December 18 through January 29). Direxion 10 Year Note Bear 2.5X (DXKSX) seeks 250% of the inverse daily results of the price of the ten-year Treasury note. It lost 40% as Treasury prices rose and gained 12% when Treasury prices fell recently. ProFund Rising Rate Opportunity 10 (RTPIX) seeks returns that are opposite the daily price movement of the ten-year Treasury note. It lost 19%, then gained 5%. Because this fund employs no leverage and uses the less-volatile ten-year note as its benchmark, it's the least risky of the funds in this group. Advertisement ProFund Rising Rate Opportunity (RRPIX) seeks 125% of the inverse daily price movement of the 30-year Treasury bond. It lost 42%, then gained 21%. Rydex Inverse Government Bond Strategy (RYJUX) seeks returns that are the inverse of the daily price movement of the 30-year Treasury. It lost 33.5%, then gained 16%. Proshares UltraShort 7-10 Year Treasury (PST) seeks daily results that correspond with twice the inverse performance of the Barclays Capital 7-10 Year U.S. Treasury Index. It lost 30%, then gained 10%. ProShares UltraShort 20 + Year Treasury (TBT) seeks daily results that correspond with twice the inverse performance of the Barclays Capital 20 + U.S. Treasury Index. It plunged 51.5%, then gained 33%. Because I'm bearish on Treasury bonds, TBT, the most aggressive fund in this group, is my favorite. As a matter of full disclosure, the ETF accounts for nearly 5% of my portfolio. I made my first purchase, in September, at about $61 a share. Given the collapse of Lehman Brothers that soon followed and the acceleration of flight-to-quality buying, my timing couldn't have been worse. But I held on and doubled my position, at about $39, on January 2. TBT closed at $47.79 on January 29, so I'm finally starting to approach break-even. I want to stress that this is not an investment for widows or orphans. Don't buy any of these funds with money you can't afford to lose. But if you agree that we're not heading into a depression and that huge federal deficits and pedal-to-the-metal monetary policies are inflationary -- and you have a bit of the gunslinger in you -- then take a flier. You may feel uncomfortable betting against Uncle Sam. But this is about making money, not taking a patriotic stand.