Best ETF Buys When Interest Rates Rise, Bonds Fall
Rock-bottom interest rates are a blast for borrowers, a sore for savers and an oncoming injury for investors.
Yields are historically low and thus have more room to rise than fall. If yields rise, bond prices fall.
The market faces "an impending rise in interest rates" as the economy improves and inflation heats up in 2014, says Jason Schenker, president of Austin-based Prestige Economics. He has recommended clients dump fixed-income assets in favor of equities, commodities and housing, which he believes will protect them against rising interest rates.
Sensitivity To Change
The longer a bond's duration, the more sensitive its price to interest rate fluctuations. As a rule of thumb, every year of duration roughly translates to a 1 percentage point change in price for each percentage change in yield.
A 1 percentage point rise in 10-year bond yield would amount to a 10 percentage point drop in the bond's price. A 1% rise in 20-year yields would generate a steep 20% loss -- a huge setback for a "safe-haven" asset.
Investors who hold until the bond matures will be paid in full, but they miss out on the opportunity to earn higher rates on their money.
The share price ofiShares Barclays 7-10 Year Treasury ETF ( IEF ) has corrected 3% from its 52-week high of 109.89 on July 25. Yields on 10-year bonds went up 0.35 point to 1.78% as of Friday from 1.43%.
The share price ofiShares Barclays 20+ Year Treasury ETF ( TLT ) -- which mainly holds 25-year bonds -- tumbled 11.4% from its 52-week high from July 25. Yields on 20-year government bonds ticked up a mere 0.43 point since then from 2.11% to 2.54%. Thirty-year bond yields climbed 0.49 point over the same period.
Investors in high-yield and investment-grade corporate bonds could get hurt even more because of emotional selling and liquidation, said Todd Rosenbluth, director of ETF research at S&P Capital IQ. He recommends buyingSPDR Barclays Capital Short-Term High Yield Bond ETF ( SJNK ). Because of its shorter duration, the share price will be less sensitive to interest rate changes. It yields 4.49%, more than Treasuries, but less than its longer duration version,SPDR Barclays High Yield Bond ( JNK ), which yields 5.9% but carries more risk.
ProShares Short 20+ Year Treasury ETF ( TBF ), designed to move opposite TLT, rises along with interest rates. It's up 9.4% from its July low.
Timothy Evans, chief market strategist at Long Leaf Trading Group in Chicago, favorsPowerShares DB U.S. Dollar Index Bullish (UUP).
"When interest rates start to rise, the dollar usually gains momentum against other currencies because higher rates attract foreign capital to investment instruments that are denominated in dollars, such as T-bills, notes and bonds," Evans said in an email. "Money chases yield and an influx in capital will be U.S. dollar friendly."
High Frequency Economics forecasts the 10-year yield will rise from an average 2.0% in the first quarter to 2.6% in the fourth quarter. The 10-year bond yield will average 2.3% this year and 2.9% next year, HFE forecasts. The 30-year Treasury yield averaged 3.0% in 2012. HFE projects it will climb to 3.4% by the fourth quarter, averaging 3.3% this year and 3.6% next.
Investors have poured an average of $3.5 billion a week into taxable-bond funds this year, up 40% from the weekly average in 2012 of about $2.5 billion, according to Jefferies.
Possibility Of Still-Lower Rates
Although most strategists see higher interest rates on the horizon, investors must brace themselves for the possibility they'll fall even further. If the stock market crashes and everyone piles into bonds as a safe haven, bond prices would rise and yields would fall.
A looming "deflationary bust" will prompt investors to dump stocks and load up on no-risk, government-guaranteed assets, says David Hunter, chief market strategist at KCCI, a brokerage firm in Jersey City, N.J. He projects 10-year bond yields will dive south of 1% and longer-term yields below 2%.
"Deflation is imminent and will trigger a 65% decline in the S&P," Hunter said in an email. "This global deflationary bust will be the result of some major monetary and fiscal policy errors. When combined with a highly overleveraged global economy, the result is an involuntary liquidation cycle."
He believes stocks, commodities and junk bonds will all lose value.
"Policymakers both here and abroad have been making some big policy errors," he wrote. "On the fiscal side, austerity is being pushed on these economies in an effort to deal with the excessive debt. Unfortunately, this austerity is putting significant downward pressure on economies that need all the revenues they can get to service their debt.
"With regards to monetary policy, central bankers around the world are pursuing monetary policies that are far more restrictive than most of Wall Street seems to understand," Hunter added.