Rather than asking ‘when’ interest rates will rise, we should ask ‘how soon’. Well, without benefit of a crystal ball, let’s say soon enough. Rates can’t stay a breath above zero forever (they’ve been there since 2008). The Federal Reserve’s Fed funds rate has spent the past year+ at a target of 0 - .25%, and from the bottom, there is only one direction to move…Up. We just don’t know how high and how fast.
Source: Federal Reserve Bank of St. Louis
The accommodative policy of the Fed is nearing an end. The central bank’s loose monetary plays will soon lead to a tightening up. The Fed’s quantitative easing (printing money) will give way to soaking up excess. And yes, interest rates will rise.
Rising interest rates can stunt economic growth, of course, but there’s more. Rising interest rates hurt bond investors. Why? Because as interest rates go up, the value of bonds goes down: as rates increase, new bond issues offer those higher rates, and the price of existing bonds falls as they lose value.
Now, during an economic crisis, Treasury securities become an oasis for investors. What better place to put your money than the default risk-free debt of the U.S. government? When the news is littered with stories of countries that can’t make good on loans, Treasury debt looks like a safe haven. That has been fine, until now. The pain in the bond market is coming, and hardest hit will be long-term securities (including Treasuries). Watching rates rise, investors will only be comfortable with short-term debt, and the value of long-term debt will fall.
What is a bond investor to do? If you want to play the bond market, you have choices. You might want to consider an Exchange Traded Fund (ETF) that will give you exposure to the market, and protect against interest rate risk. Look at iShares Barclays 1-3 Year Treasury Bond (NYSEARCA:SHY): This ETF invests in short term Treasury securities. Investing 95% of assets in U.S. government debt, this fund is considered quite safe. The short bond maturity avoids the interest rate risk that long-term bonds will face in the future.
Another choice: Ultra Short 7-10 Year Treasury Proshares (NYSEARCA:PST). This LETF works inversely; the goal is a daily return that is 2 times the opposite of Barclays Capital 7-10 Year U.S. Treasury Index performance. This means that as the long term bond fund falters, this LETF will offer even greater returns. The problem: this is a leveraged ETF, which means caution must be exercised when investing. Leveraged funds can be very volatile: 2 times the performance can mean magnified gains, or magnified losses. Leveraged ETFs are best owned for a short time if you want to capture a return; they are not designed for investors who wish to buy and hold. Due to internal compounding, it is very easy to lose if you hang on to these funds for too long; performance over any length of time over one day is very unpredictable.
Disclosure: no positions