For current bond-owners as well as shareholders of dividend-paying stocks, the last month or so hasn’t been a fun one.
The increase in Treasury yields has whittled down the price of interest-paying debt instruments and crimped prices of equities loved for the cash they regularly dole out to investors.
Rising bond yields aren’t necessarily a reason to steer clear of every investment out there, however. There are a handful of exchange-traded funds that will not only survive, but possibly thrive, in a rising-rate environment.
Let’s take a look at your top three possibilities:
Betting Against Bonds
Perhaps the easiest way to bet on rising interest rates is to bet against bonds. (Remember, as rates go up, bond prices go down.) And the easiest way to bet against bonds is by owning an ETF that increases in value as the price of bonds decreases in value. The ProShares Short High Yield ETF (SJB) could be a good option within the category, but the best bet is probably the ProShares Short 20+ Year Treasury ETF (TBF).
The inverse fund on the 20-year T-bonds is not only the most liquid of the dozen or so inverse bond funds, but it’s also the biggest pool of assets, giving its managers the most flexibility. Plus, it’s the easiest to understand: For every step back bonds take, the ETF takes on step forward.
The ProShares Short High Yield ETF is the second-most liquid inverse bond ETF, but it’s a distant second. It’s also an odd bird, “resetting” itself every day to mirror the daily moves made by the Markit iBoxx Liquid High Yield Index.
Theoretically this could make SJB a bigger mover, but the daily reset to the index’s value isn’t 100% efficient. It also requires the index to move on an intraday basis if the fund itself is to make any progress. Ergo, TBF may be the better choice, just because it’s simpler.
The risk with either fund: If yields start to stagnate or slide lower there’s not a shred of a chance you’ll break even.
Steepening Yield Curve
While broadly rising interest rates are one trend investors can combat using exchange-traded funds, that’s not necessarily the only fight investors have on their hands. For traders looking to proverbially thread the needle and hedge against a steepening yield curve — where long-term rates rise by more than short-term rates — there’s the iPath U.S. Treasury Steepener ETN (STPP).
The iPath fund is unique to say the least. The underlying portfolio owns (or is long) 2-year treasury bonds but is short (or betting against) 10-year treasury bonds. At the very least (theoretically) it will gain more with the short position than it will lose with the long position, and it’s even possible (again theoretically) that the short as well as the long positions could simultaneously make forward progress. Even without a win/win, though, it can make you money on a net basis.
The hurdle with the iPath U.S. Treasury Steepener: It works best when the yield curve steepens. If the whole yield curve just rises evenly from one end to the other, the fund’s performance is a wash.
Floating Rate ETFs
Floating rate notes may be one of the market’s unintentionally best-kept secrets.
What’s a floating rate note? It’s short-term paper (five years or less, most of the time), with coupons that change stated yield over time based on well-known benchmarks like U.S. Treasury rates or LIBOR rates. Since the payout rate on one of these notes is updated anywhere from once a month to once every six months (give or take), there’s little to no interest rate risk .
And yes, there are exchange-traded funds than can nicely package these up for investors in an easy-to-trade instrument. The top pick is the SPDR Barclays Capital Investment Grade Floating Rate ETF (FLRN), although the iShares Floating Rate Note (FLOT) is worth considering too.
Both funds are relatively new, small and perhaps a little illiquid — though that’s started to change considerably in just the past couple of weeks. The fact that they haven’t gotten crushed like most other fixed-income instruments speaks to their stability.
The downside: While the underlying principal of the funds’ bonds — and therefore the principal of the ETFs’ owners — is stable, the trade-off may be slightly lower yields than could be enjoyed by owning longer-term treasuries.
Most investors seem to be okay with that trade-off, however. FLRN is yielding about 1.5% right now vs. about 1% for FLOT, and neither’s net asset value has been walloped like bonds have of late.
As of this writing, James Brumley did not own a position in any of the aforementioned securities.