What You Need To Know About Rising Rate ETFs

need to know etfs 600X300David Fabian:  Just when you thought all of the rising rate chatter from 2013 was but a distant memory, the investment community is once again dredging up strategies to shelter your portfolio from the ticking time bomb known as your bond funds.

Ok, that last part was a little dramatic. Yet, that’s how the media and many opportunistic experts have positioned their message as we stare into the abyss of the most important Fed decision in the history of human kind.

Whether it happens in September, December, of sometime in 2016, we are more than likely going to experience some kind of interest rate hike by the Federal Reserve in the next 12-months. That event has many fixed-income experts on edge as worries over bond market liquidity and interest rate volatility threaten to change the landscape that we have become accustomed to over the last half decade.

How Rising Rate ETFs Work

I’m sure by now you have read some kind of article about how you need to own a rising rate mutual fund or ETF to fend off the madness of skyrocketing Treasury yields. Examples such as the ProShares Short 20+ Treasury Bond ETF (NYSEARCA:TBF) and ProShares Short 7-10 Year Treasury Bond ETF (NYSEARCA:TBX) are two well-known single beta ETFs in the category.

TBF and TBX are designed to track the inverse daily price movement of a basket of long and intermediate-duration Treasury bonds, respectively. These funds are essentially designed to be used as a directional bet on U.S. interest rates. In that respect, they can also be implemented as a hedge or shock absorber to dampen the impact of traditional interest-rate sensitive bond exposure in your portfolio.

If you are really aggressive, you may be urged to choose a leveraged index such as the ProShares UltraShort 20+ Treasury Bond ETF (NYSEARCA:TBT). This ETF has over $3 billion in total assets dedicated to tracking 2x the inverse daily price movement of a basket of long-duration Treasury bonds.  Remember that leverage magnifies the price movement of an ETF in BOTH directions.  Novices beware.

In addition, the Sit Rising Interest Rate ETF (NYSEARCA:RISE) is a relatively new entrant in this field with a subtly different method of owning a portfolio of futures and options contracts that targets a negative 10-year Treasury duration. One of the biggest differences with RISE is that the portfolio is re-balanced monthly rather than daily, which will impact its tracking behavior over time.

How To Use Rising Rate ETFs

Rising rate ETFs are another tool that can be added to the arsenal, but they aren’t going to be a cure-all for every aspect of your bond portfolio. They are designed to be used as short-term trading vehicles that sophisticated investors can implement in order to bet on a specific outcome (i.e. falling bond prices). In addition, these funds may be appropriate for those that wish to hedge off a portion of their bond portfolio without having to disturb existing positions.

The key to any hedge is having an appropriate position size without taking too much risk. With that goal in mind, the brain trust behind the new RISE ETF have created an “Interest Rate Defense Calculator” that may help you analyze the impact of their fund on your existing bond portfolio. You simply input your bond portfolio yield, duration, and anticipated exposure to RISE in order to determine how the overall sensitivity to interest rates will change.

I highly recommend that anyone considering making a purchase of a rising rate ETF as a hedge go through this exercise. It will provide a fresh perspective and objective data point that may play a role in determining your final allocation size.

Putting Things In Perspective

The biggest misconception about the Fed raising interest rates is that bond prices have to go down. That simply isn’t the case. The Fed doesn’t set the price of the Vanguard Total Bond Market ETF (NYSEARCA:BND), the market does based on buyers and sellers meeting at an agreeable junction.

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