3 Ways To Play Rising Interest Rates
Written by Michael Fabian, April 18th, 2013
I have spent recent weeks pondering what a real rate rise would look like, and in eventuality if the Federal Reserve will try to orchestrate a “soft landing”, or rising, as it were. Taking a page out of the Chinese Government’s playbook circa 2011-12 when the concern for keeping their economy from overheating was paramount, but treading lightly would insure that future growth wouldn’t be stunted. Something I think most experienced investors can agree on is that events rarely happen exactly the way you plan for them, or even envision them in your mind. Looking back over a more recent 20 year history it wasn’t uncommon to see half-point or full-point corrections in the 10-year treasury rate over the course of a few months, but we live in a different world now. As Mark Twain so aptly pointed out “History doesn’t repeat itself, but it does rhyme”. So the question remains, what will the next real interest rate rise look like and how should you prepare investment game plan for it? The answer is far from black and white and depending on your investing style, and what your portfolio looks like today, your actions should vary drastically.
We are all familiar with the Federal Reserve’s accommodative policies and abilities to expand its balance sheet at the mere hint of another financial crisis or recession. I also believe that if the current economy is still plagued with a lack of confidence and doesn’t continue it’s upward momentum, the Fed will do everything its power even if it needs to buy 100% of Treasury and Agency MBS issuance to keep the market afloat. Ultimately the economy will return to some normalcy, with the keyword being ultimately, but what then? With a U.S. population so accustomed to low interest rates, has the Fed committed itself to overseeing what happens next? The simple answer is of course it has, and I think the vast majority of market participants will be faked out by the Fed’s “soft landing” intervention strategy.
Investors that I have come into contact with over the years are typically only comfortable confronting a situation based upon what has worked for them in the past. With that baseline in mind, the vast majority of investors will approach a rising rate situation simply by selling every fixed income position they own, and others will strategically shorten duration or even use negative duration bond funds. The smallest portion, and the most aggressive investors will most likely short treasury bonds. There’s no correct strategy in the mix, but reviewing your options and your goals will naturally lead you to the best investment outcome for your portfolio.
An Inconvenient Truth
Except for the most nimble investors, almost every person that has “called the bottom” in rates and initiated an intermediate or long term investment in the Proshares Short 20+ year Treasury Bond Fund (TBF) or its leveraged brother, the Proshares UltraShort 20+ Year Treasury Bond (TBT) have made a costly mistake. With more and more investors wealth being destroyed by these funds, the pool has become fewer and fewer that would have faith in a fruitful outcome. For good reason I think retail investors should avoid funds like these and yield to the old adage “would you rather be right, or make money”. Very few will call the bottom, however many will expect its arrival, so your time is probably best spent analyzing a different part of the market to deploy capital to rather than taking shots at shorting treasury bonds. There are too many other opportunities in the world, and I doubt the next John Paulson will be thrust into the spotlight profiting many billions over at the demise of the U.S Treasury market, just ask Bill Gross. Its a prescient reminder that markets can stay irrational much longer than you can hope to stay solvent.
The Real World
For most retail investors the real world doesn’t involve complex shorting or hedging strategies. When was the last time you saw a fund like TBF or TBT listed as an option in a 401(k)? The world I speak of is one that has an abundance of options, but options that few investors know how and when to utilize. Those that review their portfolio often, but aren’t pouring over Fed minutes and attempting to retire off the next big trade. For this style of investing I recommend short or unconstrained duration bond funds. A few of my favorites are listed below and categorized from highest to lowest credit quality:
Short Duration Options
- iShares Core Short Term Bond (ISTB)
- Guggenheim Enhanced Short Duration Bond (GSY)
- DoubleLine Low Duration Bond (DBLSX)
- PIMCO Low Duration Bond (PTLDX)
- PIMCO 0-5 Yr High Yield Corp. Bond (HYS)
- PowerShares Senior Loan Portfolio (BKLN)
Unconstrained or Negative Duration Options
- PIMCO Unconstrained Bond Fund (PFIUX)
- Osterweis Strategic Income Fund (OSTIX)
Mind the Gap
The most virtuous man or women in the room is often the one that can sleep well at night. Knowing when to take a calculated risk, and when to simply step off the train and let others go for the ride. For the investor with little or no interest in having a first class ticket on the uncertainty express, cash should be your plan. Often advisors look down upon cash, but I’ve always found it to be a place of strength where one can evaluate and research their next investment without the anxiety of day-to-day volatility clouding their view. It reminds me of 2008, when having such a high cash position in my portfolio enabled me to focus on productive ideas, and not the turmoil the next morning would bring. Like any investment thesis, developing a plan, and then executing it decisively will ultimately produce excellent returns.