Since August, Barclays iPath has introduced two sets of ETNs that make available to smaller investors bond portfolio management tools which were previously only available through the use of futures or swaps markets. They allow investors to take positions on the particular parts of the yield curve or on the shape of the yield curve. I will focus on the first set in this article.
iPath offers bull and bear instruments on two year interest rates (DTUS, DTUL), 10 year interest rates (DTYS, DTYL) and 30 year rates (DLBS, DLBL). The “bear” instruments (ticker ends in S) increase in value with increases in interest rates, and vice versa for the bull notes (ticker ending in L).
Unlike many of the ETFs in fixed income, these instruments are based on absolute moves, not daily moves, and they are not leveraged.
While the most obvious use of these instruments would be simply to take an outright view on interest rates, the more interesting application for investors would be to make use of these as tools for modifying the risk of an overall fixed income strategy, much in the way institutional investors make use of futures and interest rate swaps.
Here are a few examples:
Interest Rate Risk Management
The bull and bear ETNs allow fixed income investors to alter the risk of their fixed income investments and exposure to the impact of changing interest rates, without the need to liquidate bond holdings. A couple examples:
1. An investor holds an existing portfolio of individual corporate bonds, including some maturing in 2021 that were purchased in 2006 at rates well above current 10-year rates and with an attractive spread over Treasuries for the bonds.
The investor has unrealized gains on those bonds but feels that long term rates have bottomed. The investor would prefer not to sell the individual bond because of issues related to liquidity, bid ask spreads and the current low spreads for high grade corporates vs. Treasuries.
By purchasing the 10 year bearish ETN, the investor would accomplish the following:
- Lock in the gains on the bond due to the fall in long term interest rates;
- Preserve the attractive spread vs. Treasuries on his existing corporate bond;
- Eliminate the need to trade out of the illiquid corporate bond;
- Retain the flexibility to easily alter his strategy in response to changes in market conditions and / or his view of the market.
2. When constructing fixed income portfolios, most investors assess their outlook for interest rates and shorten or extend maturities based on their forecast of future interest rates.
For example, in the current interest rate environment with three month T-bills at .15 and 2-year Treasuries at .61%, there is a strong disincentive for investors anticipating higher rates to lock in a two year investment.
An investor anticipating higher inflation and thus higher interest rates would keep maturities very short. This would eliminate the risk of locking in current rates and leave open the opportunity to benefit from rolling the short term investment at higher rates at a later date.
As an alternative, an investor anticipating higher rates could do the following:
- Invest cash in short term T-bills or an ETF with a very short duration;
- purchase the 2-year bear ETN.
A variation on this strategy that sought to generate higher yield would be to combine a position in a floating rate loan fund such as Fidelity Floating Rate High Income (FFRHX - yield 2.80%) combined with the 2-year bear note. The yield on the fund will rise along with short term rates and the 2-year bear note would increase in value as well.
The graph below, with 3 month T-bills (red) vs. 2-year Treasury notes (blue), shows both extremely low levels of overall interest rates as well as a large spread between three month and two year rates. A "reversion to the mean" would mean both higher interest rates and a narrower spread between the two rates.
click to enlarge images
As tools for interest rate management, these ETNs allow an investor to alter the interest rate risk of his portfolio without selling off individual bonds or trading in and out of his bond ETF or mutual funds.
“Stripping Out” Interest Rate Risk From a Bond Position
Use of these interest rate ETNs can be particularly useful for investors in municipal or corporate bonds by allowing the investor to “strip out” the interest rate risk from the credit risk out of a corporate or municpal bond position. Here are two examples:
1. Municipal Bonds
Consider the municipal bond investor who feels that the current relationship between municipal bonds and Treasuries presents an attractive opportunity. The investor is considering buying a 10-year municipal bond with yields above those of Treasuries, while the long term average is for such bonds to trade at a yield .85 of Treasuries.
However, the investor anticipates that the overall level of long term interest rates will rise, meaning that even if the spreads between munis and Treasuries revert to the mean, the investor will get hurt by the increase in the overall level of interest rates. Purchasing a bear ETN on the 10-year interest rates would eliminate the risk associated with overall interest rates and make the municipal bond purchase a “pure play” on the relative levels of munis vs. Treasuries.
2. Credit Spreads
In a similar manner, investors could take advantage of opportunities in investment grade or high yield bonds without taking a view on interest rates.
For example in a typical “flight to quality” financial panic scenario, it is very common for interest rates on government securities to fall sharply while credit spreads for both investment grade and high yield bonds move to extremely high levels. The investor who anticipates a “reversion to the mean” after the panic subsides would expect rates to rise and credit spreads to narrow. The graph below shows several periods, including 2008, when a flight to quality pushed the spread between corporate bonds (red) and Treasuries (blue) to extreme levels and then subsequently narrowed:
Thus, if this investor purchased investment grade or high yield individual bonds or ETFs, part of the gain from the narrowing of the yield spreads would be offset by losses due to the increase in interest rates. A strategy that would have combined the purchase of the credit risk bonds with the purchase of a bear Treasury ETN would, in combination with the credit bond position, create a “pure play” on the narrowing of the interest rate spreads regardless of the overall level of interest rates. I would not be surprised if an ETN is soon introduced that will offer a direct way to express a view on credit spreads
All of these strategies have been used by institutional fixed income investors for decades but they required either the complications of futures contracts, shorting bonds or ETFs and / or accesss to the institutional-only swaps markets. With these new ETNs, retail investors have some new tools for their portfolio management.
I will cover the other new fixed income ETNs on the yield curve in my next article.