One Surprising Way To Play Rising US Rates

March 18, 2015

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article is by Christopher Hugar, portfolio manager, of Buffalo, New York-based Nottingham Advisors.

With the specter of rising rates in the U.S., investors have been quick to tactically shift their bond allocations to a more defensive posture.

Mostly, we’ve seen an aggressive shortening of duration. At Nottingham, we’ve certainly shortened duration, but we’ve also complemented that approach with another shift. We’ve gone international.

Cue the raised eyebrows and general feelings of disbelief. As many of you are thinking, the interest rate environment abroad is even uglier than it is here in the United States.

In some cases, yields are even negative, meaning investors are basically paying foreign governments for the right to hold their debt! Why would anyone be interested in such a fundamentally unattractive asset class?

While that’s a fair question, we have good reasons these days to favor a solid international debt fund; namely, the Vanguard Total International Bond ETF (BNDX | B-57).

I’ll explain.

A Tale Of Two Rate Outlooks

In our view, the detractors of international bonds may be taking too much of a narrow, self-contained view. While we would agree that international bonds leave a lot to be desired when viewed in a vacuum—as in negative short-term yields—we’d argue that the asset class is better positioned than its domestic brethren over the short to intermediate term.

In the United States, economic fundamentals continue to look solid. Various sectors of the economy continue to improve, along with the labor market. Declining energy prices and renewed fiscal spending should nudge GDP growth to the 3 percent range by year-end.

With economic growth on seemingly stable footing, 2015 should mark the Fed’s initial attempts at normalizing monetary policy. Most prognosticators appear to be betting on September for the Fed’s initial “liftoff” in rates.

Market participants have seemed to adopt a similar view, as we’ve witnessed a recent uptick in interest rate volatility, and the U.S. 10-year yield has quickly climbed to the low 2 percent range after bottoming on Jan. 30 at 1.64 percent.

Outside the United States, however, it’s quite a different story.

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