By: Treesdale Partners, portfolio manager of the AdvisorShares Gartman Gold/Euro ETF (GEUR), AdvisorShares Gartman Gold/British Pound ETF (GGBP), AdvisorShares Gartman Gold/Yen ETF (GYEN) and AdvisorShares International Gold ETF (GLDE)
With the ultra low interest rate environment becoming more of a norm in many investors’ mind, complacency has driven portfolio managers to maintain the status quo and stick to traditional duration and asset allocation targets. Recent history of bond market behavior has also supported this view. On a forward looking basis, however, the important questions center around how risk/return profiles change under rising interest rate environments and what investors should consider in evaluating the risk of their current portfolio mix.
From a macro perspective, most investors would agree that given low yield levels in the current marketplace, the balance between upside and downside in bond yields is quite asymmetric when viewed over a long investment horizon. The absolute low yield levels (0.5% on the 2-year Treasury, 2.6% on the 10-year Treasury) imply that there is much more downside in price (upside in yield) versus additional upside. It is the reverse of the early 1980’s when Treasury yields reached levels in the mid-teens.
Another important factor to consider in the current environment is the narrow spread levels prevalent in the credit markets. The ample liquidity provided by the Fed coupled with the dramatic improvement in credit risk have contributed to continued narrowing of credit spreads to near the tight end of the range the market witnessed just before the credit crisis started in 2007. This bullish credit sentiment can be seen in most liquid credit products in the U.S. bond markets including corporate bonds, MBS, CMBS and ABS. The relevance of this observation is that, typically, there is a high tendency for spread levels to widen significantly in a bond market sell-off, especially if the sell-off is rapid and the market is coming out of an environment of narrow credit spreads.
Given this current backdrop, we believe there are excessive risks associated with many bond portfolios if the markets were to go through a period of rising interest rates, whether it is gradual or rapid. The major risks can be quantified and decomposed as follows. The primary risk is interest rate duration followed by the risk of widening credit spreads. As an illustration, in a scenario where interest rates rise by 50 basis points, a 10-year duration corporate bond portfolio would suffer a 5% loss due to the rate duration effect alone. Furthermore, if corporate credit spreads were to widen by 25 basis points under this scenario, there would be an additional loss of 2.5%. Another factor to keep in mind is the low coupon/yield levels which provide limited cushion against a mark-to-market loss as rates rise. In the example above, a 10-year duration corporate bond portfolio with a 5% average coupon will only be able to generate enough income to offset a mark to market loss if rates were to rise by less than 50 basis points over a one-year period. In a higher rate (and arguably more normal) environment that many investors are more accustomed to, the break-even rate rise that causes a loss on a total return basis would be greater.
Below we summarize a number of rising rates strategies that have either been discussed or implemented in the marketplace. We have highlighted some of the pros and cons of these strategies that are designed to protect portfolios against rising rates.
Hedged Aggregate Bond Index Strategy
This type of strategy provides broad exposure to different sectors of the bond market while over-hedging the duration risk. For example, the “Barclays Rate Hedged US Aggregate Bond Index, Negative Five Duration” over-hedges the US Aggregate Bond Index with enough Treasuries to attain a net duration of negative five years. While this type of exposure can potentially achieve neutral carry as the positive yield from the credit exposure offsets Treasury hedging costs, the index is highly exposed to spread widening under a rising rate environment.
Short Treasury Strategy
This strategy is based on shorting a Treasury index or a basket of Treasuries. While this type of exposure avoids spread risk, the negative carry can become expensive depending on the holding period. A levered exposure through the use of options may create a better payout profile, but at the expense of even higher carrying costs while waiting for rates to rise.
Floating Rate Strategy
A floating rate strategy involves the use of floating rate instruments to create a flat to slightly negative duration profile. As short term rates (typically LIBOR) rise, the coupon is reset to the higher index level, boosting current income. There are two caveats to this strategy, however. First, floaters will provide a modest form of income protection only if short term rates rise. If the intermediate and the long duration sectors of the Treasury yield curve rise in anticipation of planned Fed rate hikes or inflationary concerns, this strategy will not provide any immediate benefits. The second major risk is spread duration risk. While interest rate duration is neutral, most floaters have longer spread durations. A 5-year, non-amortizing floater would typically have spread duration of over 4 years. Therefore, in a rising rate environment accompanied by widening spreads, the price decline can more than offset any increases in coupon income.
MBS IO Strategy
This strategy involves the use of Interest Only (IO) instruments off agency mortgage backed securities (MBS). While this may appear complex for investors not familiar with MBS products, this strategy has many appealing characteristics if implemented the right way. First, MBS IOs have negative durations to start with due to the inverse relationship between interest rates and prepayments. As interest rates go up, prepayment rates tend to decline, increasing the value of MBS IOs. The correlation of IO valuations to Treasury movements has been very high historically. Secondly, with the right mix of coupons and pools originated in certain years, the portfolio can be constructed to have positive projected base case yields even if rates remain stable. Additionally, an attractive asymmetric profile can be set up by focusing on the right premium coupons that have greater upside in value (downside in prepayments) relative to their downside. With respect to spread risk, MBS IOs will be subject to spread widening along with all other spread products. However, a mitigating factor is that spread widening of MBS bonds should have a dampening effect on prepayments (due to higher current coupon mortgage rates) which by itself would increase MBS IO valuations, thereby offsetting the direct impact of wider MBS IO spreads. One hurdle in implementing this strategy for some investors is complexity and product expertise.