Negative Duration ETFs For Rising Rates

February 11, 2015

If there’s one question I’ve gotten more often in the last two years than any other, it’s, “What do I do about rising interest rates?”

 

It’s a simple question with a surprisingly complicated answer. First off, let’s consider the actual economic impact of rising rates.

 

In the current low-interest-rate environment, two major things happen. The first is that the actual coupon payments you get for owning a bond are low. That 10-year Treasury bond is only going to pay you 2 percent between now and when it matures. That makes investors less likely to want to own bonds versus other assets, so, theoretically, it’s good for things like stocks.

 

Low Rates ‘Theoretically’ Good
The second reason low rates are theoretically “good” is that it makes it cheaper for companies to borrow money. That’s why Apple keeps floating enormous bond offerings. It only has to pay a little more than the federal government—about 3.5 percent—for a 10-year bond, and the company would rather do that than move cash from overseas bank accounts and pay taxes.
 

More traditionally, it means a manufacturer can borrow cheap in order to build things such as factories and hire more workers, and that’s good for stocks and for the economy.

 

But rates are never completely static. We’ve been in a market of slowly lowering rates for a long time. And while that means your coupon payments for buying in are going down, if you were already holding a bond, its price has been going up.

 

That’s why long Treasury ETFs like the iShares 20+ Year Treasury Bond ETF (TLT | A-85) have been among the best-performing ETFs in any asset class—up 24 percent in the last year alone. 

Chart courtesy of StockCharts.com

 

Now What To Do?

It’s understandable that investors who have perhaps ridden the huge principal gains of the declining-rate bull market are now concerned that the rates set by the market and those set by the Fed seem to be turning positive.

 

The traditional way of knowing how your bond portfolio is going to be affected by a change in interest rates is duration. The rule of thumb (which is mostly right) is that for every 1 percent shift in interest rates, the principal value of your portfolio should shift in the other direction by the duration.

TLT has a duration of about 18 years; so if rates go up 1 percent, you’d expect it to go down 18 percent. There are other things at work (the shape of the yield curve being the biggest one), but it gets the job done as a yardstick.

 

How than, do you profit from rising rates?

 

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