The spring storm in the Treasury market is leaving bondholders scrambling for shelter. Since March 17, the yield on the 10-year Treasury note has gone from 3.65% to 4.42% at one point (on Wednesday) and investor sentiment toward Treasuries is at its lowest in at least 12 years, according to a weekly poll of clients by J.P. Morgan Chase. Some analysts, like Andrew Harding, portfolio manager for Armada Funds, say the majority of the damage already has been done, but rates could still possibly rise another 25 to 50 basis points by year's end. Paul Mendelsohn, technical strategist for Windham Financial, offers a gloomier forecast, saying that "if the 10-year breaks through 4.66%, there's not much resistance until 5.5%, which was the high in March 2002." Nevertheless, for fixed-income investors searching for that elusive umbrella in the sudden storm, there are a few strategies to consider in a rising rate environment.
The ProFunds Rising Rates Opportunity fund is a souped-up version of the Rydex fund. It employs leverage in the form of futures contracts and swaps -- the exchange of one security for another -- to seek results that produce 125% of the inverse of the price movement of the long bond. Or, put more simply, if the price of the long bond falls 1%, the value of the fund's shares should rise by 1.25% before fees come into play. Both funds have been on a tear in the past four weeks as the long bond has fallen. Rydex's fund is up 7.53% while ProFunds fund has gained 9.07% through April 13. Morningstar analyst Todd Trubey says the Rydex and ProFunds inverse bond funds offer fantastic returns when interest rates rise sharply, but the difficulty, and the danger, is in getting the timing right. "This is an aggressive bet to make for the average investor," says Trubey. "Professional bond fund managers have been waiting 18 months for rates to rise and they have been wrong for the majority of the time." Last summer was a perfect example of a period when the timing was right as rain for inverse bond funds. During the months of June and July in 2003, 30-year Treasury yields shot up from a June 1 low of 4.34% to a July 31 peak of 5.44%. As a result, the Rydex fund was up 15% for the two-month period and the ProFunds fund, due to its levered approach, rose about 18.5%. Unfortunately, in the year preceding that run-up, both funds suffered harshly from rising bond prices and falling yields, as the Fed either cut official interest rates or implied it wasn't about to raise them because of slow economic growth and deflation concerns. From May 2002 to May 2003, the Rydex fund was down 20.3% and the ProFunds fund was down 25.2%.
Trubey suggests investors' best bet is to use these funds as a hedge against large bond portfolios. For example, investors holding laddered bond portfolios, or a group of bonds with a range of maturities, can use inverse bond funds to help neutralize the deteriorating values of the remaining bonds in their portfolio. A final word of caution concerning these two particular inverse bond funds: They have high fees for what is essentially a fixed-income index fund in reverse. Rydex charges an expense ratio of 1.41%, a percentage equal to the Morningstar average for equity funds and over 0.25% higher than the average bond fund. The ProFunds fund charges an outsize expense ratio of 1.94%, but then again, it's a fund seeking outsized gains.
In order to combat the problem of time decay, Smith suggests investors buy at-the money put options - meaning options with a strike price equal to the price where the stock is currently trading - with at least 9 to 12 months remaining until expiration. Expect the TLT to move 1 point for approximately each 11-basis-point change in the 10-year's yield. So in order for investors to make money on their puts, even in a 9-12 month time period, rates really need to rise swiftly and sharply. For example, on Wednesday April 14, with the TLT priced at $84, the January 2005 $84 puts (at the money) were trading at $5.60 and the 10-year Treasury note was yielding 4.40%. In order to make money on the puts, the TLT price needs to sink below the break-even price of $78.40 ($84 minus $5.60), meaning rates would have to rise to 5.01% before investors started making money. These investment strategies may be more complicated than most, but for those expecting a long-awaited series of Fed rate hikes, they may be worth your interest.