By David Stevenson –

It is, of course, one of the least well kept secrets within the shady world of international finance, that at some stage our collective national pension scheme pots will be mutilated by a substantial fall in the value of government securities particularly, and bonds generally, following an interest rate increase.

David Stevenson assesses ETF strategies for dealing with a rise in interest rates.

Rather than worrying about the effect on the pensions gap from a FTSE 100 decline, we’ll be panicking about why the global leviathans of institutional finance were so heavily invested in government debt. We’ll blame the regulators for forcing the pension fund managers into a corner by overly cautious policies. We’ll then blame the central banks for tapering and taking their profits on massive bond portfolios – even though they’ll presumably also be suffering from booking losses as the selling intensifies. And then we’ll blame the poor old companies standing behind the remaining DB schemes for failing to stop this slow car crash!

Over in wealth management land the impact will be a little less devastating, but it will nevertheless be painful. For decades investors have been spoon fed the dream that fixed income investing was (a) riskless as well and (b) profitable. Until of course it wasn’t. Maybe the dramatic drop in gold prices will remind investors of the essential and only verifiable law of economic thermo-dynamics, which is that what goes up dramatically in price, must eventually come down dramatically in price.

In practice, I suspect the mundane realities of money management will make a bad job much worse. Trying to seriously talk investors out of a big shift away from fixed income into just about anything riskier (and I include cash in that) is nigh on impossible. Investors will dabble, rotate their exposure, slightly reduce their fixed income component, even get a tad adventurous – but they won’t fundamentally restructure their allocations because they falsely believe that capital preservation is the only aim of wealth preservation and in practice that equates to buying bonds.

This dystopian picture for bonds is obviously informed by my own particular investment world view – that bonds represent poor value at best and dreadful value at worst, especially in a future where inflation might rear its ugly head. In reality, regardless of my views, bond prices are currently anchored in a firmly deflationary world view – that growth will be anaemic and possibly turn into a recession after the next black swan event.

Maybe the deflationists are right and maybe we will all carry on charging into the deflationary valley of hell (as articulated by Societe Generale’s perma-bear Albert Edwards) with bond prices inching even higher. But on virtually every possible alternative account of what could happen in the future, bonds are a bad investment over the long term.

The big question then becomes what to do about it? In reality most investors and their advisers don’t have the luxury of saying “I’ve had enough of this wonderful decade of bonds investing and I’m off, selling my entire portfolio…so long and thanks for the fish”. They maybe want the alleged capital security and low volatility of bonds. Maybe they need the income. Maybe they need both, made worse by their adviser’s aversion to sudden portfolio changes.

I think it’s fair to say that the vast majority of investors don’t really have the option of just dumping bonds as an asset class. Instead, they have to be creative about reshaping their risk exposures, and cranking up the income yield without taking too much risk. What should they do, especially if they use ETFs to gain their fixed income exposure?

The most obvious answer is to hedge one’s exposure, with the most direct method being to make money on any future decline in the price of bonds. Over here in Europe the choices aren’t that extensive, although DeAWM and ETF Securities do offer notable products in the space, but in the US there’s now a growing body of short bond trackers garnering decent amounts of money. I have no doubt that within a year we’ll see the big European ETF companies look to follow suit, hoping to build on the approx. $1.2 billion in assets under management for short bond trackers.

The star performer in the US has been the JP Morgan Double Short US 10 Year Treasury Futures ETN (DSXJ) providing 2x inverse exposure to 10-year US Treasury bonds, which has returned over 100% (as 11/11/2013). But the biggest, in terms of assets under management, is, by a long country mile, the ProShares UltraShort 20+ Year Treasury ETF (TBT), which has gathered more than $400 million in assets. What these two products intimate, is that if you’re looking to actively hedge by shorting, look for a fall in the price of 10- and 20-year maturity US government bonds.

My issue, though, with these short ETFs and ETNs is not that I think these won’t continue to be excellent performers at some point in the future…but one of timing! I’m not sure that the deflationists won’t be right for at least the next few months or even few years. I can absolutely see growth rates slow and maybe even falter, necessitating even more QE. I don’t think this situation is PROBABLE but it is POSSIBLE, and to bet on short bonds you need more certainty than this.

That opens up the next option which is to hedge in a more passive way by trying to take as much duration risk out of the equation as possible. That’s where a couple of innovative ETFs with built in interest rate hedges from ProShares come into their own. In Europe, iShares also offers a couple of products following a similar technique. These ETFs target a duration (a measure of interest rate sensitivity) of zero by shorting Treasury, or, in the case of the iShares funds, bund, futures.

According to Proshare’s Michael Sapir, “investors have been fleeing long-term bond funds as concerns grow over losses that might result from rising interest rates. While many investors have moved to shorter duration bond funds to lessen the impact of rising rates, they remain exposed to some interest rate risk”.

If we look under the bonnet of these funds, using the ProShares High Yield – Interest Rate Hedged ETF (HYHG) as an example, we discover that this index actually consists of “a long position in investment grade corporate bonds and a duration-matched short position in US Treasury bonds. The investment grade portion of the index offers exposure to the more liquid, cash-pay bonds, with each issuer limited to 3% of the market value of the investment grade corporate position of the index”.

According to Proshares, the “short position in US Treasury securities is constructed using three US Treasury securities corresponding to the 10-Year US Treasury Note Futures, US Treasury Bond Futures and Ultra US Treasury Bond Futures contracts in an attempt to approximate the maturity distribution of the overall index”.

If this all sounds fairly complicated, in Europe iShares, along with SSgA SPDR and DeAWM db X-trackers, offer a much simpler solution. Rather than hedge away your interest rate risk, why not reduce the risk levels using short maturity bond trackers. This doesn’t mean that you are immune from any bonds sell off following an increase in interest rates but it does lower your risk levels.

Back in October, for instance, iShares listed three passive ultrashort bond ETFs – the iShares Euro Ultrashort Bond UCITS ETF, iShares $ Ultrashort Bond UCITS ETF and iShares £ Ultrashort Bond UCITS ETF (the last one is based on the recently launched Markit iBoxx Liquid Ultrashort Index).

According to iShares, these ETFs “invest primarily in fixed and floating rate investment grade corporate bonds denominated in euros, US dollars and sterling respectively, with the fixed rate bonds maturing between zero and one year and floating rate bonds between zero and three years”.

All five ETFs are physically replicating optimised funds, purchasing and holding the underlying bonds. The total expense ratio for the ultrashort bond ETFs is 0.2% and ranges between 0.2% and 0.45% for the short duration products.

According to Tom Fekete, Head of Product Development for iShares in EMEA, “Developed economies are on the long path of slow and steady growth, and it is widely anticipated that the low interest rates of recent years will eventually start to climb…Long dated bonds are particularly impacted by rising interest rates, and fixed income investors are derisking by shifting their emphasis towards shorter duration bonds that are less exposed to changes in these rates. At the same time, investors who have been on the sidelines of the market are looking for ways to increase their returns, and short duration bonds can offer greater yield than some cash investments for those looking to put their cash to work”.

Turning away from specific ETF solutions, I think the time has now come for bond investors to become aggressively pragmatic – and more than a little dynamic – and consider a number of sensible tactics including:

Diversify your bond holdings as a general rule, and consider a greater variety of instruments and underlying markets in order to spread out any risk of big losses following specific market/national/regional macro-economic blow ups!  In the world of active bond fund management, many managers are, for instance, looking to deploy a number of strategies to diversify their risk levels, including some of the ideas detailed below, but also careful selection of individual securities and issuers.

Their message is ‘pick carefully’ and don’t bet too much on any one individual issuer. Consider shortening your duration risk by moving away, for instance, from longer duration fixed income securities and pushing one’s bond allocation to ‘short’ maturity assets. Equally, some higher yielding, riskier securities have lower duration risk especially if bond rates do start to rise i.e. these bonds are less vulnerable to sudden sell offs in Treasury bills and bonds and tend to bounce back quite quickly as confidence returns.

Be careful about how you invest in riskier, lower-rated assets i.e. only invest in the more liquid markets where you know that if risk levels do rise you can easily liquidate your positions. Many emerging market bond markets have been shown in recent weeks to be relatively illiquid and shallow with no buyers of bonds from distressed investors

Look to invest in alternative forms of bond indices where the index developers have consciously attempted to control risk levels either by rating an issuer based on their perceived  risk level using key macro-economic measures or by excluding certain sectors such as banks (within corporate bonds) where the volatility of bond prices might be excessive.

Last, but by no means least, consider moving some of your fixed income exposure into floating rate or even inflation-linked securities, especially if you believe that there is a substantial increase in interest rates on the cards. Inflation-linked securities represent poorer value but could very easily come into their own if inflation levels start to rise above 5% globally, following a sudden surge in economic activity.

The views and opinions expressed herein are the views and opinions of the author, David Stevenson, and do not necessarily reflect those of ETF Strategy.