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Interest Rate Hedge

Interest Rates Rising, Stocks on the cusp-The Anthology of Astrology in the Spirit of Money?

Date:   6/20/2005 9:40:49 AM   ( 16 y ) ... viewed 2065 times

How to Hedge Against a Rate Rise

By Gregg Greenberg
TheStreet.com Staff Reporter
6/20/2005 7:02 AM EDT
Click here for more stories by Gregg Greenberg



Looking for protection against rising interest rates? You've got two options, each with its pros and cons.

The question arises as investors once again weigh whether the latest rate jump is for real. That's a big if, given numerous head fakes lately.

Still, rates have bounced back after bottoming on May's weak jobs report. Following a brief spell below the psychologically important 4% level, the yield on the 10-year note has clawed its way back over 4.10%. Now, many big players in the bond market expect it to hit 4.26%, its average yield in 2004.

If you're among those who are convinced that rates are on the rise, you can either buy so-called inverse mutual funds, or you can short fixed-income exchange traded funds.

One way is to buy open-end mutual funds that use derivatives to move in the opposite direction of the 30-year Treasury bond, also known as the long bond. The $2.4 billion Rydex Juno Investor fund and the $600 million ProFunds Rising Rates Opportunity fund, which also uses 25% leverage, are two that do just this. Another fund, the $64 million Potomac Contrabond fund, seeks to double the daily price movement of the 10-year Treasury note -- just in the other direction.

Another option is to sell short U.S. Treasury-based ETFs such as the $4 billion iShares Lehman 1-3 Year Treasury (SHY:Amex - commentary - research), the $1 billion iShares Lehman 7-10 Year Treasury (IEF:Amex - commentary - research) and the $740 million iShares Lehman 20+ Year Treasury Bond (TLT:Amex - commentary - research).

Needless to say, there are issues you should consider seriously before taking either course. The so-called inverse bond funds can give you a good hedge, but they bring hefty fees and little transparency. The ETFs are cheaper and more transparent, but of course shorting brings its own set of challenges. We'll outline the pros and cons of each approach below.
Just Wait 'Til Next Year

Before betting the farm that interest rates will keep rising, though, investors might pause to consider the last year's action. Rates were significantly higher a year ago, when the last thing the market expected was for them to plummet to their current levels. Back then, inflationary fears and forecasts for strong economic growth had the yield on the 10-year note as high as 4.83%.

Furthermore, the yearlong decline in long-term rates has come in the face of Fed Chairman Alan Greenspan's best efforts to push up rates via multiple short-term rate hikes.

The unexpected slide hasn't been kind to mutual funds betting on rates. The Rydex Juno fund, for example, is down 16% since last June and down just over 6.6% this year. The ProFunds Rising Rate fund has taken a bigger hit, since it employs leverage to goose returns -- or, in this case, widen losses. It is down 21% since last year and 9% year to date.

The Potomac Contrabond fund, even though it uses leverage, has outperformed the other two, since its duration is shorter. It is down 12% since last year and 3% year to date.

Duration is very important to consider when trying to gauge inverse bond fund returns. Juno's duration is 14 -- which means that it should gain between 10% and 15% when interest rates rise a percentage point. Leveraged funds, of course, would have higher returns corresponding to the amount of juice involved.

If the big turnaround is at hand, and yields continue higher, then inverse funds provide a great deal of flexibility and convenience for investors looking for a hedge. Where selling short fixed-income ETFs can involve lofty margin requirements and big transaction fees, investors can buy and sell rising-rate funds just like any other open-end mutual fund.

And unlike shorting stocks, there are no lending desks or compliance officers involved when you invest in a fund. Also, many retirement portfolios are not allowed to short stocks, but they are allowed to buy funds like Juno. Minimums, however, are higher than average, which is why active traders and institutional investors often dominate the action in these funds.

"You need clearance to short stocks, but with funds, you just put the money in," says Anne Ruff, co-portfolio manager for the Juno fund. "And at some brokerages, you need extra money to cover the dividends while that's included in Juno."

A big drawback facing inverse funds is their costs. The ProFunds Rising Rate, Juno and Potomac Contrabond funds carry steep expense ratios of 2.42%, 1.38% and 1.75%, respectively. Such fees are far steeper than any regular bond fund, where the average cost is around 1% for actively managed funds and 0.40% for index funds -- which these funds really are, only in reverse.

Morningstar analyst Todd Trubey warns investors against using Juno and funds like it for speculative purposes due to the unpredictability of interest rates and high costs. But he adds that investors with short time horizons could use it "to hedge losses in a bond portfolio."

What About ETFs?
There are now more than 160 ETFs available in all shapes and sizes, from large-cap value to small-cap growth, along with country funds from Singapore to Switzerland. Despite the massive growth in this industry, however, there are only six fixed-income ETFs, which is especially curious considering the heft of the $24 trillion bond market. (The U.S. Treasury market is just over $4.1 trillion; the rest is corporate and municipal bonds.)

The three ETFs tracking the U.S. Treasury market are offered by ETF powerhouse Barclays Global Investors. Each ETF tracks a different segment of the yield curve: The SHY focuses on the short end at one to three years, the IEF on the middle at seven to 10 and the TLT on maturities of 20 years and longer.

The price of the IEF back in June 2004 was $80, but it has since risen 7.5% to $86 as yields have fallen. The TLT, which tracks the Lehman 20+ years Treasury index, has risen from $80 to $94 over the same period.

If investors think these ETFs are looking toppy, they may choose to short them, or sell borrowed shares with the hope of buying them back later at a lower price. Some of the main advantages of shorting fixed-income ETFs, as opposed to buying inverse bond funds, are lower costs and greater transparency
Although there are individual transaction costs, the underlying expense ratio for the SHY, IEF and TLT is 0.15% -- far below the cost for the funds. And unlike the funds, which comprise short sales, derivatives and futures contracts that might have tax consequences for holders, Treasury-based ETFs are simple and transparent.

"The core feature of the fixed-income ETFs is the transparency of the costs and holdings," says J. Parsons, managing director at Barclays Global Investors. "You know what you own, so you can better decide whether it's the right product for you."

Parsons also downplays the oft-heard criticism that institutional investors and hedge funds often hoard shares of the TLT and IEF, making it difficult to borrow.

"It's hard to believe that it's such a major problem," says Parsons. "We heard the same thing in 2000 when people were trying to short tech stocks."

Also, unlike tech and other stocks, ETFs can be shorted on a downtick, and the supply of shares can be increased to satisfy lending demand.

According to BGI, the current duration of TLT is 13.09, roughly the same as the Juno fund. Hence the TLT would be expected to change in value by 13.09% if rates moved up or down a percentage point. The IEF's current duration is 6.59, so it would be expected to change by 6.59%.

Investors shorting fixed-income ETFs are required to pay the current yield that the bond would pay, as would the purchaser of an inverse bond fund. Currently, the SHY is yielding 2.25%, while the IEF and TLT are yielding 3.68% and 4.26%, respectively.

"With yields so low and volatility increasing on long-term bonds, people are seeing less and less of a reason to be in the TLT," says Kevin Ireland, vice president for ETFs at the American Stock Exchange.

Judging by the nearly 50% rise in short interest on the TLT since last year, that's hard to dispute.

To view Gregg Greenberg's video take on how to protect your portfolio amid rising interest rates, click here.

Although there are individual transaction costs, the underlying expense ratio for the SHY, IEF and TLT is 0.15% -- far below the cost for the funds. And unlike the funds, which comprise short sales, derivatives and futures contracts that might have tax consequences for holders, Treasury-based ETFs are simple and transparent.

"The core feature of the fixed-income ETFs is the transparency of the costs and holdings," says J. Parsons, managing director at Barclays Global Investors. "You know what you own, so you can better decide whether it's the right product for you."

Parsons also downplays the oft-heard criticism that institutional investors and hedge funds often hoard shares of the TLT and IEF, making it difficult to borrow.

"It's hard to believe that it's such a major problem," says Parsons. "We heard the same thing in 2000 when people were trying to short tech stocks."

Also, unlike tech and other stocks, ETFs can be shorted on a downtick, and the supply of shares can be increased to satisfy lending demand.

According to BGI, the current duration of TLT is 13.09, roughly the same as the Juno fund. Hence the TLT would be expected to change in value by 13.09% if rates moved up or down a percentage point. The IEF's current duration is 6.59, so it would be expected to change by 6.59%.

Investors shorting fixed-income ETFs are required to pay the current yield that the bond would pay, as would the purchaser of an inverse bond fund. Currently, the SHY is yielding 2.25%, while the IEF and TLT are yielding 3.68% and 4.26%, respectively.

"With yields so low and volatility increasing on long-term bonds, people are seeing less and less of a reason to be in the TLT," says Kevin Ireland, vice president for ETFs at the American Stock Exchange.

Judging by the nearly 50% rise in short interest on the TLT since last year, that's hard to dispute.

To view Gregg Greenberg's video take on how to protect your portfolio amid rising interest rates, click here.




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