How To Maintain Income Potential While Betting On Rising Interest Rates by Bradley Krom, Fixed Income & Currency, The WisdomTree Blog
Over the last several months, the Federal Reserve (Fed) has continued to reiterate its stance that any shifts in monetary policy will depend on continued improvement in economic data. Over this period, employment data has continued to show signs of improvement, making it increasingly likely that the Fed will finally lift rates on September 17. In the Fed’s opinion,1 it may be only a matter of time until decreases in the employment rate ultimately lead to gains in economic growth and a coincident rise in inflation.
One of the biggest conundrums for investors has been how to prepare for a coming shift in interest rates. Many investors have moved to shorten the duration of their portfolios — thinking long-term interest rates could not remain stuck near historically low levels. While a Fed rate hike is likely the first step, an important determinant of longer-term rates is what usually happens when the Fed starts to allow its balance sheet to shrink. Without the Fed continuing to reinvest the proceeds of maturing securities, the size of its balance sheet would begin to decline, ultimately weighing on the long end. This likely reaction would be primarily due to the disappearance of the Fed as a captive buyer in the market. In our view, exposure to a high-yield debt strategy with negative duration could be one way to accrue income while waiting on rising interest rates.
Return Driver 1: Rising Rates
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Typically when interest rates rise, bond prices fall. How much they fall can be approximated through a measure of a security’s duration. The price of a bond with a seven-year duration will fall by approximately 7% for every 1% increase in interest rates. Therefore, if an investor is short a security with a seven-year duration, the investor stands to profit by 7% in the above scenario. While most hypotheticals assume a parallel shift in the yield curve—for example, interest rates rise by 1% across every point—this rarely occurs.
Below, we illustrate this through an examination of the exposures of the WisdomTree BofA Merrill Lynch High Yield Bond Negative Duration Fund (HYND). This strategy invests in high-yield bonds and then shorts Treasury futures contracts in order to achieve a negative-seven-year duration.
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While the total duration of the portfolio is approximately negative seven years, you can see that it achieves this exposure by selling futures in the 3-7 Years and 10+ Years segments of the yield curve. Therefore, if rates rise only at the short end, the strategy could underperform. But if the yield curve steepens (long rates tend to rise faster than short rates), this portfolio should perform quite well. During the most recent period of rising rates this year,2 this is precisely what occurred.
Return Driver 2: High-Yield Credit
In addition to exposure to interest rate risk, HYND is also exposed to credit risk. In our view, any increase in rates by the Fed should be taken as an endorsement by policy makers that the strength of the U.S. economy is continuing to improve. With the economy strong, the probability that risky borrowers will default should continue to remain low.
As a result, we believe investors can enhance return by assuming additional credit risk. At the portfolio level, the long positions in high-yield bonds help to finance the cost of the short positions. Should credit spreads and nominal interest rates remain unchanged, an investor could potentially accrue income in excess of 3% per year while waiting for the thesis of rising rates to play out.3
So far in 2015, credit has underperformed as commodity prices fell and fears of a Greek exit from the eurozone weighed down certain non-investment grade borrowers. However, with stability potentially creeping back into the market, we believe that credit risk could be attractively priced. Compared to other rising rate strategies that only short securities, investors in HYND have the potential to accrue income in excess of the Barclays U.S. Aggregate Index (Agg) while maintaining a negative duration portfolio.
In fact, during the most recent period of rising rates in 2015, HYND has been a valuable diversifier for strategies with similar exposures to the Agg, as we show below. Although returns are comparable between the two strategies for the entire period, the drivers of returns differ drastically. Longer-term interest rates rose dramatically from the end of January through mid-July, ultimately driving strong performance for HYND. However, rates eventually retraced to unchanged on the year through the end of July. This move allowed the Agg to turn modestly positive year-to-date after spending the last several months in negative territory.
Comparable but Differing Drivers of Total Returns
Barclays U.S. Aggregate Index vs. HYND YTD: 12/31/14-7/31/15
The Risks of an Anti-Recession Portfolio
Now that we’ve discussed and witnessed the potential drivers of return in real time, it is important to understand the risks. HYND can largely be viewed as an anti-recession strategy. If it appears that a recession may be coming, high-yield spreads would likely widen, and long-term interest rates could fall—resulting in negative performance for both bets in HYND. Additionally, it is possible that interest rates could rise at the short end, but not necessarily the long end. In this environment, an investor would have the right trade rationale, but ultimately not be able to profit from the resulting move in the market.
Ultimately, our view continues to be that the U.S. economy can continue to expand at a moderate pace. In response, it may only be a matter of time until stronger growth ultimately leads to a rebound in inflation expectations. Through the combination of higher nominal interest rates and historically low levels of default risk, we believe that HYND could make sense for an investor who wants to accrue some income while positioning portfolios to benefit from a rise in longer-term rates.
1Source: Based on comments made by Atlanta Federal Reserve President Dennis Lockhart, “A Story of Economic Progress,” Federal Reserve Bank of Atlanta, 8/10/15.
2Refers to period 1/31/15–7/13/15.
3Source: WisdomTree, as of 7/31/15.
This blog must be proceeded or accompanied by a prospectus. We advise you to consider the Fund’s objectives, risks, charges and expenses carefully before investing. The prospectus contains this and other important information about the fund. Please read the prospectus carefully before investing. Call 866-909-WISE (9473) or visit wisdomtree.com for more information.
Important Risks Related to this Article
There are risks associated with investing, including possible loss of principal. High-yield, or “junk,” bonds have lower credit ratings and involve a greater risk to principal. Fixed income investments are subject to interest rate risk; their value will normally decline as interest rates rise. The Fund seeks to mitigate interest rate risk by taking short positions in U.S. Treasuries, but there is no guarantee this will be achieved. Derivative investments can be volatile, and these investments may be less liquid than other securities, and more sensitive to the effects of varied economic conditions.
Fixed income investments are also subject to credit risk, the risk that the issuer of a bond will fail to pay interest and principal in a timely manner, or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline. The Fund may engage in “short sale” transactions where losses may be exaggerated, potentially losing more money than the actual cost of the investment and the third party to the short sale may fail to honor its contract terms, causing a loss to the Fund. While the Fund attempts to limit credit and counterparty exposure, the value of an investment in the Fund may change quickly and without warning in response to issuer or counterparty defaults and changes in the credit ratings of the Fund’s portfolio investments. Due to the investment strategy of certain Fund’s they may make higher capital gain distributions than other ETFs. Please read the Fund’s prospectus for specific details regarding the Fund’s risk profile.