“I can resist anything but temptation,” Oscar Wilde once remarked. His comment may be apt in relation to the portfolio posture one should adopt in anticipation of rising interest rates. After all, one is not really sure to what degree interest rates will rise—or even if they will rise. Clearly, there is a risk in buying longer-dated securities with higher yields if rates were to rise. There is also a risk in buying shorter-dated securities if rates do not rise.
For discussion purposes, let us assume that the 10-year Treasury rate is 2.56% and that it will be 4.56% in 24 months—this is not a prediction, but merely a hypothetical example. If it were to yield 4.56%, however, the 10-year Treasury 24 months hence would be an 8-year Treasury. If rates increase to that magnitude, the then-8-year Treasury would be trading for a price of 86.72 in relation to par. Inclusive of income, this would result in a negative 4.17% compound annual rate of return.
Alternatively, let us assume, should interest rates rise, that one purchased the Western Asset Mortgage Defined Opportunity Fund (DMO), a closed-end fund currently trading at a 6.9% discount to NAV. This fund has an average maturity of 6.9 years and a current yield of 8.03%. It is 10.78% leveraged. Even though this is comprised of mortgage paper and its maturity is shorter than the 10-year Treasury, we will nevertheless presume that the price of this fund will decline by the amount of the 10-year Treasury multiplied by the leverage factor. When you multiply the negative rate of return of a 10-year Treasury of roughly 14% by 1.1078 (the leverage factor is 10.78%) and ignore any return due to mortgage principal amortization and the accretion of those securities towards par (because, theoretically, 24 months from now they will be 5-year mortgages) there is no mitigation of the negative rate of return. However, one would collect the current yield of over 8%.
Including income collected over the course of 24 months—given probably an aggressively high assumption for principal decline in a rising-rate environment—the fund would provide a positive annualized rate of return of 74 basis points per annum, or 4.91% per annum more than the purchase of a 10-year Treasury. This assumes, of course, that the discount to NAV of the closed-end fund does not widen, and certainly it may widen.
Rates are so low for most fixed income instruments that the problem of return in the fixed income dimension cannot be solved by the avoidance of maturity or yield curve risk— which is to say, by buying fixed-income securities of sufficiently short duration so there will be no meaningful depreciation whatever the rate increase, if any. There also will be no meaningful rate of return.
See Full PDF here: Fixed_Income_Contrarian_Compendium_September_2013