Falling in love is one of the greatest experiences on earth. However, it also leaves us blind to the flaws or shortcomings of our counterpart. That is how I feel about bonds right now with the 10-Year U.S. Treasury Yield (TNX) at 1.56% and continuing to crater lower on an almost daily basis in June.
I fully understand the fundamental drivers of this move, which is being fed in large part by a deluge of foreign buyers seeking asylum from negative interest rates. Fund flows have also confirmed that some areas of the bond market are now seeing allocations at 3 ½ year highs. See this recent post from The Fat Pitch blog.
Many investors have been burned by their stock and commodity positions so much over the past 18-months that they are gobbling up low volatility fixed-income to shore up the defense. It has become more of a momentum and fear trade than any rational foundation of long-term value.
This type of positioning and sentiment screams of excitement, which is why I am becoming more cautious.
I have long been a proponent of owning a nice slug of bonds as a measure of diversification, income, and portfolio stability. However, with yields this low, I have been starting to rein in my exposure to interest rate sensitive holdings and evaluate positions with closer scrutiny. Put simply, I’m not blindly letting my passion for bonds cloud my judgement of generating positive total return and preserving capital.
Below are some strategies you can employ to insulate your portfolio from a backup in interest rates if you feel, as I do, that the pendulum has swung too far in one direction.
1. Shorten Your Duration
If you own funds like the Vanguard Extended Duration Treasury ETF (EDV) or the iShares 20+ Year Treasury Bond ETF (TLT), then you have exposure to a great deal of interest rate risk. These funds tend to be top performers when interest rates fall. However, longer duration bonds are going to be more susceptible to losses in value when we see a change in interest rate trends.
Moving to a fund with a lower effective duration will help mitigate these losses and allow you to lock in gains on highly appreciated holdings. One actively managed ETF I utilize for my income clients is the SPDR Doubleline Total Return Tactical ETF (TOTL), which has an effective duration of 3.78 years. That is nearly 1/3 less interest rate risk than the iShares Core U.S. Aggregate Bond ETF (AGG), which has an effective duration of 5.23 years.
2. Move to Cash
Another option to consider is simply scaling back one or two of your bond funds that have the greatest exposure to interest rate risk. Having some additional cash on hand will reduce the stress of any swift reversals in Treasury yields and enhance your flexibility.
I don’t advocate selling everything and calling a top right here because prudence dictates you maintain some core exposure in a diversified portfolio. However, you can easily reduce your positions sizes or sell tactical holdings that will free up capital for potentially higher yielding opportunities down the line.
3. Make a Directional Bet On Rising Rates
The final option to consider is a more aggressive bet on yields rising through an inverse bond ETF such as the ProShares Short 20+ Year Treasury Bond ETF (TBF). This option is more appropriate for short-term traders who are comfortable taking positions that are inversely correlated to the market.
I don’t advocate shorting bonds for the majority of investors because it’s expensive, it’s difficult to time, and if you get it wrong you can do far more harm than good. Nevertheless, in a year like 2013 when bond yields exploded to the upside, there was an opportunity to capitalize on this movement.
Disclaimer: inverse trades should be short-lived with disciplined risk management plans for only the most competent traders.
The Bottom Line on Bonds: A Dose of Active Management
My gut tells me that with an accommodative Federal Reserve, low economic growth rates, and overall global circumstances that we will continue to experience the phenomenon of “low interest rates” for quite some time. Remember, we started the year at 2.25% on the 10-Year Treasury bond. Just seeing a backup to that historically low level would result in a massive shift in positioning and sentiment for many fixed-income investors.
In my opinion, a reasonable amount of active management and counter-intuitive mindset can help cushion the impact of a reversal and becoming overly bullish on duration at these levels will be proven foolish.