Comparison of Rising Rates Strategies

July 18, 2014

by Yung Lim
of AdvisorShares
By: Treesdale Partners, portfolio manager of the AdvisorShares Gartman Gold/Euro ETF (GEUR),
AdvisorShares Gartman Gold/British Pound ETF (GGBP), AdvisorShares Gartman Gold/Yen ETF
(GYEN) and AdvisorShares International Gold ETF (GLDE)
With the ultra low interest rate environment becoming more of a norm in many investors mind,
complacency has driven portfolio managers to maintain the status quo and stick to traditional
duration and asset allocation targets. Recent history of bond market behavior has also supported
this view. On a forward looking basis, however, the important questions center around how
risk/return profiles change under rising interest rate environments and what investors should
consider in evaluating the risk of their current portfolio mix.
From a macro perspective, most investors would agree that given low yield levels in the current
marketplace, the balance between upside and downside in bond yields is quite asymmetric when
viewed over a long investment horizon. The absolute low yield levels (0.5% on the 2-year Treasury,
2.6% on the 10-year Treasury) imply that there is much more downside in price (upside in yield)
versus additional upside. It is the reverse of the early 1980s when Treasury yields reached levels in
the mid-teens.
Another important factor to consider in the current environment is the narrow spread levels prevalent
in the credit markets. The ample liquidity provided by the Fed coupled with the dramatic
improvement in credit risk have contributed to continued narrowing of credit spreads to near the tight
end of the range the market witnessed just before the credit crisis started in 2007. This bullish credit
sentiment can be seen in most liquid credit products in the U.S. bond markets including corporate
bonds, MBS, CMBS and ABS. The relevance of this observation is that, typically, there is a high
tendency for spread levels to widen significantly in a bond market sell-off, especially if the sell-off is
rapid and the market is coming out of an environment of narrow credit spreads.
Given this current backdrop, we believe there are excessive risks associated with many bond
portfolios if the markets were to go through a period of rising interest rates, whether it is gradual or
rapid. The major risks can be quantified and decomposed as follows. The primary risk is interest
rate duration followed by the risk of widening credit spreads. As an illustration, in a scenario where
interest rates rise by 50 basis points, a 10-year duration corporate bond portfolio would suffer a 5%
loss due to the rate duration effect alone. Furthermore, if corporate credit spreads were to widen by
25 basis points under this scenario, there would be an additional loss of 2.5%. Another factor to
keep in mind is the low coupon/yield levels which provide limited cushion against a mark-to-market
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loss as rates rise. In the example above, a 10-year duration corporate bond portfolio with a 5%
average coupon will only be able to generate enough income to offset a mark to market loss if rates
were to rise by less than 50 basis points over a one-year period. In a higher rate (and arguably more
normal) environment that many investors are more accustomed to, the break-even rate rise that
causes a loss on a total return basis would be greater.
Below we summarize a number of rising rates strategies that have either been discussed or
implemented in the marketplace. We have highlighted some of the pros and cons of these
strategies that are designed to protect portfolios against rising rates.
Hedged Aggregate Bond Index Strategy
This type of strategy provides broad exposure to different sectors of the bond market while over-
hedging the duration risk. For example, the Barclays Rate Hedged US Aggregate Bond Index,
Negative Five Duration over-hedges the US Aggregate Bond Index with enough Treasuries to attain
a net duration of negative five years. While this type of exposure can potentially achieve neutral
carry as the positive yield from the credit exposure offsets Treasury hedging costs, the index is highly
exposed to spread widening under a rising rate environment.
Short Treasury Strategy
This strategy is based on shorting a Treasury index or a basket of Treasuries. While this type of
exposure avoids spread risk, the negative carry can become expensive depending on the holding
period. A levered exposure through the use of options may create a better payout profile, but at the
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expense of even higher carrying costs while waiting for rates to rise.
Floating Rate Strategy
A floating rate strategy involves the use of floating rate instruments to create a flat to slightly
negative duration profile. As short term rates (typically LIBOR) rise, the coupon is reset to the higher
index level, boosting current income. There are two caveats to this strategy, however. First, floaters
will provide a modest form of income protection only if short term rates rise. If the intermediate and
the long duration sectors of the Treasury yield curve rise in anticipation of planned Fed rate hikes or
inflationary concerns, this strategy will not provide any immediate benefits. The second major risk is
spread duration risk. While interest rate duration is neutral, most floaters have longer spread
durations. A 5-year, non-amortizing floater would typically have spread duration of over 4 years.
Therefore, in a rising rate environment accompanied by widening spreads, the price decline can
more than offset any increases in coupon income.
MBS IO Strategy
This strategy involves the use of Interest Only (IO) instruments off agency mortgage backed
securities (MBS). While this may appear complex for investors not familiar with MBS products, this
strategy has many appealing characteristics if implemented the right way. First, MBS IOs have
negative durations to start with due to the inverse relationship between interest rates and
prepayments. As interest rates go up, prepayment rates tend to decline, increasing the value of
MBS IOs. The correlation of IO valuations to Treasury movements has been very high historically.
Secondly, with the right mix of coupons and pools originated in certain years, the portfolio can be
constructed to have positive projected base case yields even if rates remain stable. Additionally, an
attractive asymmetric profile can be set up by focusing on the right premium coupons that have
greater upside in value (downside in prepayments) relative to their downside. With respect to spread
risk, MBS IOs will be subject to spread widening along with all other spread products. However, a
mitigating factor is that spread widening of MBS bonds should have a dampening effect on
prepayments (due to higher current coupon mortgage rates) which by itself would increase MBS IO
valuations, thereby offsetting the direct impact of wider MBS IO spreads. One hurdle in
implementing this strategy for some investors is complexity and product expertise.
AdvisorShares
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