Negative Duration ETFs For Rising Rates

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?

Fluctuating Rates & Yields

Well, there are two ways. The first is to simply invest in securities whose yield will fluctuate with interest rates overall. That’s the theory behind funds like the iShares Floating Rate Bond ETF (FLOT | 77). It holds floating-rate bonds that will start paying more in interest if interest rates go above a certain floor in the London Interbank Offer Rate.

The only problems with funds like FLOT and its competitors is that they tend to be very short term, and thus low yielding in the first place. Over the last year, FLOT has returned just 30 basis points.

Some folks also worry about the credit-quality implications—if you’re a company issuing a floating rate bond, it will get harder to pay those coupons as the rates go up, potentially increasing the chance you default.

Most floating-rate bond funds have durations close to zero—their principal likely unaffected by changes in rates, but their yield keeping up, in theory.

Shorting Bond As Rates Rise

The second, fancier way to profit from rising rates is to actually bet against bonds. After all, if you think Apple is going down, you short it. Why not do the same thing with TLT? In fact, TLT has around 19 million shares short, or some $2.5 billion.

Back in August, that number was almost twice as high. While not a shockingly large percentage of the fund’s $7.6 billion in AUM, it’s nevertheless a short favorite.

And of course, the truly adventurous can use inverse funds like the $900 million ProShares Short 20+ Year Treasury ETF (TBF), which, thanks to the magic of rebalancing math, was down “only” 22 percent in the last year.

But what if you don’t want to actually go to the hassle of shorting TLT, or maybe you’re not allowed to in your brokerage account?

Well, there are funds for that—negative-duration ETFs, specifically two from WisdomTree, the WisdomTree Barclays U.S. Aggregate Bond Negative Duration ETF (AGND | C-39), and the WisdomTree BofA Merrill Lynch High Yield Bond Negative Duration ETF (HYND | D-31).

AGND, with a negative duration of about -6, is the “big” fund in the space, with almost $27 million in assets. HYND, with a negative duration of about -8, has just $6 million. Neither one has truly found its legs in terms of appeal or trading yet, but they may soon.

Both funds function similarly, owning a portfolio that tracks a big, traditional bond index on the one hand (which will indeed pay coupons and generate yield) but then more than hedge all their duration risk by selling Treasury futures. Those futures act as an embedded short position in duration.

So in the case of AGND, what you're actually getting is the portfolio of the popular iShares Core Barclays Aggregate ETF (AGG | A-98) and a lot of short Treasury exposure. As you can imagine, with Treasurys on a tear for the last year, this has been a bet the wrong way:

Not as disastrous, perhaps, as being on the wrong side of TLT’s 24 percent return, but a bad bet nonetheless.

Calling an entry point for when rates will really start to rise is perhaps foolhardy, but I do see more interest in these types of products, and would expect more to come to market throughout the next few years.

Duration hedging hasn’t yet had its “hedge the yen” moment—when investors discovered the power of currency hedging en masse. But like currency-hedged ETFs, duration-hedged ETFs may start finding a place not necessarily as core holdings, but as finely honed tools for tweaking duration exposure in a broader bond-portfolio context.

At the time this article was written, the author held no positions in the securities mentioned. You can reach Dave Nadig at [email protected] or on Twitter @DaveNadig.