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.
There are innumerable scenarios that could play out that would negate a rising interest rate environment or create a choppy trend. That would ultimately make a rising rate ETF expensive and frustrating to own when analyzed against other comparable opportunities. Remember that timing is a key aspect of hedging or betting against the natural flow of a market cycle as well. If your timing is off, you are going to feel the pain of being in the wrong spot at the wrong time.
Your bond portfolio plays an important role in diversification, income, and low volatility. In addition, it may be made up of several interlocking sectors, credit profiles, duration exposure, and fund managers that will adjust as conditions in the fixed-income market’s change.
Some investors may prefer simply reducing their core exposure to intermediate-duration bonds and moving to cash or a lower-duration equivalent in order to adapt to a rising rate environment. While you would forgo a higher income stream for a short period of time, it would allow you to preserve capital and look to redeploy when prices and/or yields appear more attractive.
The Bottom Line
No one knows what the future may bring with respect to interest rates and expected returns from bond funds. I am anticipating and prepared for the likelihood that we will experience very fast moves in both directions. As a result, investors that have adopted a trading mindset and quick feet, may ultimately achieve a profitable outcome from rising rate ETFs.
Nevertheless, I urge you to fully research and understand how these ETFs function before you add them to your portfolio. Taking the extra time to compare their impact on your existing positions and implement a risk management plan will also aid in your success.
This article is brought to you courtesy of David Fabian.