From the September 2013 issue of Research Magazine • Subscribe!

August 26, 2013

Are You Ready for Rising Rates?

“Interest rates have nowhere to go but up!” That’s the tune prognosticators have been singing for five years, and they’ve been dead wrong. Until now.

“Interest rates have nowhere to go but up!” That’s the tune Wall Street’s prognosticators have been singing over the past five years, and they’ve been dead wrong. Until now.

After hitting a yearly bottom of 1.63% on May 1, the yield on 10-year U.S. Treasuries (IEF) recently zoomed ahead to near 2.6%. Investors who own individual bonds or a bond fund will likely have seen something unfamiliar in their mid-year statements: bond value losses.

What’s your game plan for hedging investment clients against higher interest rates?

Steeper Yield Curve

This year’s rout in bond prices has done more than just raise interest rates; it’s also increased the yield curve.

As the yield curve steepens, the difference or spread between long-term and short-term interest rates increases. This causes long-term bonds to decrease in value relative to bonds with shorter maturities.

Many pundits and economists theorize a steepening yield curve is good for the economy, as it’s a sign of future growth and inflation. One justification they provide is that the steeper curve is great for banks (XLF) because they make their money on the net income margin.

Another popular argument is that a rising yield curve suggests an improving economic climate. Business Insider recently wrote, “When yields are rising from a low level, they reflect improving prospects for economic growth.” Maybe in theory, but a glance at reality suggests otherwise.

Higher interest rates have already taken a toll on mortgage activity. The weekly refinance index has fallen by more than 50% since early May, according to the Mortgage Bankers Association. Likewise, other rate sensitive sectors like REITs (VNQ) and Utilities (XLU) have pulled back.

For perspective, the chart nearby shows the historical yield spread between 10-year Treasury yields and the federal funds rate (FFR). The yield spread between both benchmarks has never been more than 400 basis points or 4%. And today, with 10-year yields now around 2.6% and the FFR between zero and 0.25%, the 10-year yield would need to shoot up to 4.35% to break historical records. That leaves a potential 1.85% upside in 10-year yields, should the FFR hold steady and should rate relationships stay within their historical limits.

Rebalancing Needed

As bond yields rise, bond prices fall. Because of their sensitivity to rate spikes, long-term bonds and Treasuries have fallen the hardest. The iShares Barclays 20+Yr Treasury ETF (TLT) has declined 10% since early May.

Conversely, ETFs that own Treasuries with shorter maturities like the Vanguard Short-Term Government Bond Index Fund (VGSH) and the PIMCO 1-5 Year U.S. TIPS (STPZ) have declined less than 2%. The value of bonds with shorter maturities is less impacted by rising rates.

“Fixed-income investors should be particularly cognizant of liquidity levels, keeping maturities short and spread duration low. High-yield spreads may widen by another 100 basis points because of the recent Treasury crash,” said Scott Minerd, Guggenheim Partners’ global chief investment officer.

Because long-term U.S.Treasuries have been star performers ever since the 2008-09 financial crisis, many bond investors piled into them chasing higher returns and higher yields. Treasury prices have been further inflated by the Federal Reserve’s Treasury purchases via “QE” or “quantitative easing.”

Regardless of the Fed’s deliberate attempt to keep rates artificially low, the interest rate dynamic has quickly changed from down to up. And for the first time in a while, unsuspecting bond investors are experiencing something they haven’t grown accustomed to: losses from bonds. Rotating away from longer into shorter bond maturities is one way to help clients ease the pain of higher rates.

Taking the Offensive

Besides moving to safer shorter-dated Treasury bond ETFs, another tactic to capitalize on a steepening curve is to buy the iPath Treasury Steepener ETN (STPP). The note has already rallied over 15% since May and would benefit if the yield curve keeps steepening. Past episodes of steepening have sent the yield curve over 250 basis points higher from its lows. If that again is the case, then the yield curve still would have over 150 basis points upside, providing a windfall for STPP owners.

Another strategy for dealing with higher rates is to take the offensive by investing in ETFs that are designed to increase in value when bond prices fall because of rising interest rates.

ETFs that gain from falling bond prices like the Direxion Daily 20+ Yr. Treasury Bear 3x Shares (TMV) and the ProShares UltraShort 2x 20+ Yr. Treasury ETF (TBT) are ahead between 10.5% to 14% over the past three months. Both funds use daily leverage of 300% and 200% and are designed to increase in value when long-term Treasury bond prices fall.

More gains for TMV and TBT could be ahead if the yield on 10-year U.S. Treasuries dances with 3%.

Direct Hedging

For clients that still want to keep exposure to the bond market, but with hedged protection, there are a few solutions.

The ProShares High Yield Interest Rate Hedged ETF (HYHG) owns high-yield bonds while simultaneously holding short positions in U.S. Treasury futures. The fund charges 0.50% annually and attempts to capture the credit spread between its long and short positions while minimizing interest rate risk.

Another strategy is to purchase temporary insurance via protective put options on Treasury ETF positions. Buying out-of-the-money put contracts a few months into the future is one way to limit costs. And while the outlay to buy insurance may eat into yield, clients may appreciate the peace of mind in knowing their bond positions are protected.

Conclusion

The silver lining of rising interest rates, if there’s any, has been a lack of inflation. This allows investors to keep more of their yield income. Unfortunately, the threat of inflation never goes away.

For now, educate your clients by helping them understand the inverse relationship of bond prices and bond yields. Show them how increasing rates are especially destructive to owners of long-term bonds. And once they’re educated, they’ll be more convinced to take action.

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