It has been a bumpy ride for income investors this year as the dreaded demon of rising interest rates has finally reared its ugly head.
From May through August, we saw a tremendous rise in the 10-year Treasury note yield which slashed bond prices and sent fixed-income investors fleeing for the relative strength of stocks or the safety of cash.
But talk about rising interest rates has cooled recently in the wake of the Federal Reserve’s decision in September to continue its current pace of asset purchasing. This news ultimately sent bonds and other interest rate sensitive securities soaring as money flowed back into defensive-minded sectors to take advantage of depressed prices and higher rates. Speculation over the timing of the Fed changing its policies has many jittery bond investors worried about how they will ultimately hedge their current holdings or shift their portfolios to alternative asset classes.
With the 10-Year Treasury note yield currently sitting near 2.50%, Barclays recently recommended that investors short intermediate-term Treasury bonds. This is based on the expectation that yields will climb to 2.75% by year-end.
Another way to take advantage of this rising rate opportunity is to purchase an ETF that moves inverse to Treasury bond prices such as the ProShares Short 7-10 Year Treasury (TBX). More aggressive traders could even select a 2x leveraged ETF such as the ProShares UltraShort 7-10 Year Treasury (PST), which will double the inverse daily returns of the bond index.
However, keep in mind that leverage increases risks to the downside as well and can enhance losses if interest rates continue to fall. They key to successfully trading an inverse fund is to have a strict sell discipline in place to guard against a potential reversal.
And this is a gutsy call considering that many Fed watchers ultimately expect that the slowing rate of jobs growth will delay a decision to change monetary policy until 2014. For most traders, this represents a short-term opportunity with limited upside potential based on a relatively benign forecast of 0.25% move in interest rates. More than likely, the Barclays note is geared towards larger institutional investors and futures traders that can access these markets with size and capitalize on short-term moves.
In my opinion, the more likely scenario to play out is that interest rates will trend sideways for the remainder of the year and may even continue their recent descent if stocks get weak. Traditionally a correction in the stock market will lead to a bid in bonds as investors flee to safer harbors.
My preferred method of facing interest rates right now is to shift core bond holdings to shorter duration securities. This still allows you to take advantage of the income-producing characteristics and capital appreciation potential of bonds without the same amount of interest rate risk as long or intermediate-duration securities.
Investors that are looking to take advantage of short-duration funds may want to consider the PIMCO 0-5 Year Corporate Bond ETF (HYS) or the Vanguard Short-Term Corporate Bond ETF (VCSH). Both of these funds pay monthly income, are low in volatility and have been in solid uptrends this year.
Investors have numerous tools at their disposal to play the bond market over the next several months, whether it’s hedging your portfolio with a rising rate fund or switching to a shorter duration alternative. The option that you choose will likely be based on your risk tolerance, trading discipline, time horizon and investment objectives.
Remember: Even in the face of rising interest rates there will be sectors of the bond market that continue to outperform and having the right income-seeking strategy in place will be key to navigating these choppy waters.
David Fabian is Managing Partner and Chief Operations Officer of FMD Capital Management. As of this writing, he did not hold a position in any of the aforementioned securities. To get more investor insights from FMD Capital, visit their blog.