I haven't thought about investing in bonds lately because I can't imagine yields dropping much, and I'm not all that thrilled with current yields. Is there an easy way to bet on rising rates without taking a position in futures? -- Michael Carroll
Sorry I didn't get a chance to answer your letter sooner -- you wrote on Jan. 29 -- but this way, everyone gets to see how awesome your interest-rate forecasting ability is. Since you wrote, Treasury yields have risen by roughly 50 basis points!
Think rates are going to keep rising? First, let me state the general principle that, in the realm of fixed-income investments and derivatives, the only way to make money from rising rates is at the
Chicago Board of Trade
, where you can short or buy put options on Treasury bond and note contracts. If the price of the contract falls, the prices of put options (which give the owner the right to sell at a certain strike price at expiration) will rise.
As long as you know what you're doing, options on Treasury futures aren't beyond the reach of most investors. The futures themselves require a major capital commitment. The Treasury bond contract, for example, closed at 120 30/32 yesterday, with each price point equal to $1,000, for a total of nearly $121,000. But the June 118 puts, a bet that the contract will trade lower than 118 at expiration, closed at 53/64, with each 64th equal to $15.625 for a total of $828 and change.
But assuming you're not interested in that, your goal should be to choose fixed-income investments that best hold their value as rates rise. "Almost everything is going to come down, so you want to pick something that's going to come down the least," says Mariana Bush, closed-end fund analyst at
It helps to understand two basic principles of bond investing.
First, all things being equal, the longer the maturity of a bond, the more its price will change given a change in yield.
Second, all things being equal, the bigger a bond's coupon, the less its price will change given a change in yield.
I found this second concept confusing when I first started learning about bonds because it seemed to contradict the first: The longest-maturity bonds have the biggest coupons, but aren't they also the most sensitive to changes in interest rates?
Yes, but that's not what the theorem is saying. The theorem is saying that if you have two bonds
of the same maturity
and one has an 8% coupon and the other has a 6% coupon, the 8% coupon bond will be less sensitive to changes in interest rates. Its price will rise less if yields fall and fall less if yields rise.
The investment implications are pretty simple: If you want to bet that rates are going to rise, you want bonds with large coupons compared with other bonds of the same maturity. What kind of bonds are those? Bonds of relatively low quality, such as high-yield bonds. They are the ones that pay high interest rates (large coupons) to compensate investors for credit risk.
The strategy makes sense from an economic standpoint. If interest rates are rising, they're probably rising because the economy is going like gangbusters. And if the economy is going like gangbusters, those speculative-grade companies that issued the high-coupon bonds are probably doing OK.
It's not a foolproof strategy by any means. "Very often, when Treasuries sell off, the selloff can be even greater in less-liquid names," says Dan Peirce, head of emerging markets research at
BancBoston Robertson Stephens
Improving credit quality may accompany rising interest rates, but only to a point. "Depending how long it lasts, you have to ask how long will the economy be able to do well if interest rates keep rising, and how will corporations do if they have to pay higher interest rates," he explains. But Peirce also says that, as
discussed in this space two weeks ago, yields on high-yield bonds are high enough by historical standards to compensate you nicely for that risk.
What if you can't stomach the credit risk? Then, according to the first principle, you want to pick investment-grade bonds with relatively short maturities. If you're going to buy a bond fund, that means something short- or intermediate-term. Beware of staying too short, though. You can protect yourself from interest-rate changes by staying in a money-market fund, but often at the cost of a significant amount of income. "People who've stayed too liquid have really been left at the train station," says Marilyn Cohen, president of
Envision Capital Management
, a Los Angeles money-management firm. Remember that a rise in interest rates will cause the value of your principal to drop, but your income will be reinvested at the higher rates.
A couple of other suggestions for bond bears from previous Fund Forums:
floating-rate loan funds, a species of closed-end funds, and
Treasury Inflation-Protected Securities, or TIPS.
Elizabeth Roy answers your bond fund questions every Friday. Dagen McDowell answers general mutual fund questions Monday through Thursday. Send questions on either topic to
firstname.lastname@example.org, and please include your full name.
TSC Fund Forum aims to provide general fund information. Under no circumstances does the information in this column represent a recommendation to buy or sell funds or other securities.