On Rising Rate Funds, or, Who Remembers ARM Funds in the Early ’90s? By David Merkel, CFA of Aleph Blog
In the early 90s, there were not many investment actuaries. One of the Holy Grail ideas of the early-to-mid ’90s was creating floating rate funds with yield so that floating rate Guaranteed Investment Contracts could be profitably written. I chronicled my efforts there in this article.
One avenue that I went down and rejected was ARM [Adjustable Rate Mortgage] funds. There was a minor craze for them in the early-to-mid ’90s, and there were not enough ARMs issued to meet the demand for high floating rates. As such, the prices for blocks of ARMs rose above par, sometimes significantly.
One truism of buying mortgages at a premium in the ’90s was that the ability to refinance got sharper and sharper. Those willing to buy mortgage securities above par usually took losses as rates fell.
Thus when I read articles about rising rate ETFs, which either invest short-term, or short the bond market synthetically or actually, I think “we’ve been here before.” It is difficult to gain incremental yield on short duration instruments without taking on risks like:
- Credit, including weak covenants
- Structure (another form of credit & illiquidity)
- Negative optionality
So be wary here. Pay more attention to the return of your principal than the return on the principal.