Income Now And Protection Against Rising Rates

Includes: BKLN, FLOT, TIP
by: JAR Financial Management

On December 27, I published an article in which I state my belief that an excellent long-term risk versus reward investment is to start building a short position in long-term treasury bonds. Many readers of the article have contacted me asking if there are more conservative ways to shield themselves from interest rate rises and inflation besides the two ways I listed in the article. There are and this article will provide a high level overview of them. These investments were not written about in my previous article because I consider them to have very different risk versus return characteristics relative to shorting bonds. There are three items I would like you to keep in mind while reading this article. First, there are investment vehicles and investment strategies. For the purpose of this article, I will be focusing on investment vehicles. Strategies vary from laddering techniques to capturing spreads by shorting long-term bonds and investing the proceeds into Ginnie Mae Securities. The second item to keep in mind is to understand the difference between inflation and interest rates. Often times we tend to use the two interchangeably. We do so because interest rates are often used to manipulate inflation. The Fed could lower rates in an attempt to stimulate the economy and introduce inflation or raise interest rates in response to inflation as it did in the 70s. However, interest rates can very for other reasons such as credit spreads widening and economic uncertainty (see Greece for example). Please understand that interest rates and inflation are NOT the same thing. The third item to keep in mind is that I am referring to individual bond characteristics in this article not characteristics of funds that invest in the bonds. Each fund will have its own underlying features that must be examined separately before investing.

The first investment vehicle is referred to as bank loans or floating rate loans. These loans are often shorter duration (by duration I am referring to the bond's price sensitivity to changes in interest rates) with a coupon that adjusts at predetermined intervals relative to a benchmark. These characteristics tend to cause the bond to trade near par and have been considered low risk because of this. Investors must understand one important trait regarding these investments. They are extremely exposed to credit risk. This was a major aspect many investors overlooked in 2008. It was common to see these funds having losses greater than 22% in 2008. Before investing in these funds, please read the prospectus to understand exactly what that specific fund is invested in. Two popular ETFs that invest in these bonds are IShares floating rate note (NYSEARCA:FLOT) and PowerShares senior loan portfolio (NYSEARCA:BKLN). One example of a mutual fund is Franklin floating rate daily access (MUTF:FAFRX). These investments will primarily protect investors from interest rate increases.

The second investment vehicle and probably the most noted vehicle are TIPS (treasury inflation protected securities). These investments as their name indicates will help shield investors against inflation and focus on real returns. These investments are relatively new in the United States (they were first introduced in 1997). The principal value of these investments is adjusted for changes in the consumer price index (CPI) on each semiannual coupon date. This allows the nominal coupon, which is the real yield multiplied by the change in CPI-adjusted principal, to increase with inflation. When the bond matures the CPI-adjusted principal is reimbursed. Often, the inflation adjustment to the principal will be paid out immediately instead of being paid out at final maturity. One critique that is often brought up in regards to TIPS is that real inflation may not be captured by the CPI because of the way CPI is calculated and what items are included in the index. Therefore, investors may not be as hedged to inflation as they thought they were. A popular ETF that consists of TIPs is the IShares Barclays TIPS bond (NYSEARCA:TIP).

The third vehicle will protect investors from rising interest rates. These are adjustable rate mortgage securities (ARMs). I will be focusing specifically on Fannie Mae adjustable rate securities for this article. Investors have long viewed Fannie Mae as risk free (as long as the government continues to bail it out). Adjustable rate mortgages are similar to floating rate notes in that the rates periodically reset relative to a benchmark and therefore trade close to par. If you look at the famous mutual fund term sheet where it demonstrates how $10,000 would have grown over x amount of years in XYZ fund, you will notice that the graph consistently moves up (close to linear) including 2008. This is a result of the aforementioned view that these securities are risk free. This will hold true as long as this view stays intact. One example of a mutual fund that invests in these securities is Franklin adjustable U.S. Government (MUTF:FISAX). Currently, I am unaware of an ETF that focuses solely on these investments.

The fourth vehicle is less known to retail investors. It will also protect investors from rises in interest rates. This investment is referred to as SBA loan pools. SBA pools are comprised of SBA loans (Small Business Association). These loans are backed by the full faith and credit of the United States government (similar to treasuries). These loans have a predetermined step-up in coupon rates at predetermined times. There are a few reasons that SBA loan pools may not protect you fully against interest rates. If current market rates are below the stepped-upped coupon rate then the loans will be refinanced. If current rates are higher than the stepped-upped coupon rate then the loans will not be refinanced and investors are left with a lower coupon paying bond than what is currently available in the market. I stated earlier that these investments are less known to retail investors. This stems from the limited supply of these loans. Since they are limited in supply, most brokers either chose not to use them or they require the investor to have a minimum amount. For example, I know a few firms that require investors to have a minimum of one million dollars to invest in these funds. I am not referring to a one million dollar portfolio but to a minimum of this amount strictly for these investments in addition to their other portfolio holdings.

Lastly, investors tend to use two other investment vehicles as well. The first is an investment in stocks that pass through inflation or are sensitive to interest changes (import/export businesses and the effects on exchange rates). The second is commodity investing. I will not go into details in this article regarding these two approaches for the following reason; they are often used in conjunction with other investment thesis besides one that focuses only on inflation/interest rate changes, specifically stock investments, and these topics would require an article by themselves. I don't believe an additional article would even do these topics justice given the fact that there are textbooks written solely about them. In the near future, I will be doing a brief article about commodity investing but it will be focusing on increasing correlations and the use of commodity indexes for investing and not focusing on using them as inflation hedges.

Hopefully this helps those who are trying to find more conservative ways to rotate their investments within their portfolios to protect from rising rates and higher future inflation (relative to shorting bonds). As I always recommend, whatever you chose to use, please take the time to understand the investment and also take the time to research whichever ETF or mutual fund you decide on.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.