Keeping Your Interest Up - ETFs For A Rising Interest Rate Environment

by: Alan R. Myers

There has been much talk in the past few weeks about the Fed's reduction of bond buying and what that will do to interest rates. If the Fed tapers their quantitative easing - dubbed "QE Infinity" in some circles - this will certainly begin to put upward pressure on interest rates. In fact, we are already seeing this phenomenon in the longer dated Treasury bonds, with interest rates on the 30-year Treasury bond climbing from just over 2.8% in early-May to over 3.6% as of mid-July. Much of this is a result of Ben Bernanke's comments before Congress that the Federal Reserve was prepared to taper their bond buying "within the next few meetings."

The one thing to keep in mind is that bond prices and bond yields are inversely related. That is, the lower the price of a bond, the higher the yield on that bond. Think of it like this. You buy a bond that pays 3% interest semi-annually. That is, on a bond with a face value of $1,000 you would receive $15 every six months. Fast forward six months and assume that newer bonds are being sold with an interest rate of 5% to buyers. Would you want to own an older bond that only pays $30 each year or one that pays $50 each year? Most rational folks would choose the higher yielding bond, so what happens to the older bond (think eBay here)? Everyone sells it to pile into the newer, higher yielding bonds. And when everyone sells, price falls. This is why bond prices are inversely related to interest rates (for bonds already outstanding).

This raises a big question for investors in bonds - is there any safe hiding place in fixed income? The short answer is "there may be." There are five different ideas that investors might want to consider for the fixed income portions of their portfolio. The key thing to note here is that these ideas are not necessarily meant for capital appreciation but are meant as a shelter from rising interest rates - a way to preserve capital hopefully without sacrificing too much yield.

Duration - One option is to look at short-duration bond funds. Duration is a measure of how quickly you get your money back on a bond. The shorter the duration, the quicker you recover your investment in the bond. This is just a fancy way of saying that you want to look at bond funds holding bonds that mature sooner rather than later. The key reason for this is the sooner the bond matures, the less likely it is to drop significantly in price if interest rates rise. If you are holding a bond that matures in one year and one that matures in 30-years, the 30-year bond is going to drop farther in value than the 1-year bond if interest rates increase one percentage point, all else being equal. By holding bonds that mature sooner, this affords some protection from the interest rate increase that is inevitable and would allow you to gradually shift to higher yielding bonds as they become available. The three largest exchange traded funds in this space include the SPDR Barclays Short-Term Corporate (SCPB) with a duration of 1.97 years, a 30-day SEC yield of 0.89% and a dividend yield of 1.35%, the iShares Barclays 1 - 3 Year Credit Bond (NYSEARCA:CSJ-OLD) which also has a duration of 1.97 years, a 30-day SEC yield of 0.67% and a dividend yield of 1.43%, and the Vanguard Short-Term Corporate Bond (NASDAQ:VCSH) which has a 2.9 year duration, a 30-day SEC yield of 1.28% and a dividend yield of 2.07%.

Another idea in this space would be to look at the Guggenheim BulletShares series of bond funds. These are funds with specific maturity dates such as the 2014 Corporate Bond (NYSEARCA:BSCE), 2015 Corporate Bond (NYSEARCA:BSCF), 2016 Corporate Bond (NYSEARCA:BSCG) and so forth. Currently the 2014 Corporate Bond fund has a 30-day SEC yield of 0.53% and a distribution yield of 1.19% while the 2015 series has an SEC yield of 0.71% and a distribution yield of 1.43%. The nice thing about this series of funds is that you can easily build a bond ladder with the series and have instant diversity across each series - something that is impossible to do without hundreds of thousands of dollars elsewhere. The down side is that you might end up with some credit concentration risk in some of the series. For example, the 2014 fund has 54% of its assets in the financial sector and you have to go out to the 2018 series before exposure to the financial sector drops below 50%. Another issue with the BulletShares is that they currently trade at a small premium to NAV. When yields are already low, paying a premium to buy a basket of bonds only lowers the total "yield to maturity" that you will earn. We would be more inclined to purchase at NAV or, better yet, at a discount to NAV.

Converts - Another option is to look at convertible bonds. Convertible bonds are a special case of bonds. These are bonds that are issued with a special "kicker" - the ability to convert your bond into shares of the underlying company stock. For example, Intel has a couple of different convertible bond issues outstanding. The 2009 debentures, which mature in 2039, pay 3.25% semiannually but they can be converted into 45.05 shares of Intel (NASDAQ:INTC) common stock, which is equal to $22.50 per share. So, if Intel trades for more than $22.50 (currently INTC is selling for around $24.00 per share), it might make sense to buy the bond, convert and sell the shares. This is almost like buying a bond and a call option - an option that gives you the right to buy a stock at a certain price - in one package. The option portion of this bond - the right to buy the stock at a fixed price - should increase along with the underlying stock price just as a normal call option would, thus increasing the price of the bond. If the economy really is getting better, then stock prices should continue rising, increasing the value of these convertible bonds. Currently there is only one ETF that covers the convertible bond space and that is the SPDR Barclays Convertible Bond (NYSEARCA:CWB). This fund has a 30-day SEC yield of 2.48% and a dividend yield of 3.82%.

High Yield - Another option - and certainly a more risky one - is to look at the "junk" bond space. Junk bonds, or high yield bonds, typically trade differently than ordinary corporate bonds. Junk bonds are often more equity-like in nature, typically making them less correlated to interest rates. Generally, you want to buy high yield bonds at the bottom of a business cycle when everything looks the bleakest. This is when default rates on these bonds are the highest and yields are greatest. As the business cycle improves, most businesses will normally benefit, so the default rate for these more troubled companies drops and bond prices rise as the perceived risk in these companies declines. You typically want to sell out of these junk bonds at the top of the business cycle - when everything is coming up roses.

So, if you believe the business cycle still has a ways to go before we are firing on all cylinders, this would argue that junk bonds still have some life left in them. The only drawback to this argument is that many investors and investment advisors have piled into junk bond funds in recent months - most notably the iShares iBoxx $ High Yield Corporate (NYSEARCA:HYG) and SPDR Barclays High Yield Bond (NYSEARCA:JNK). Many investors bought these funds only because the yield on them was north of 6 or 7%. With no idea how investing in junk bonds typically work, there is a chance these investors may come piling out of these funds as interest rates rise and move into safer funds. So this is an area to tread cautiously. With that caveat, the two powerhouse funds in this space are the two mentioned above. The iShares fund has a 30-day SEC yield of 4.99% and a distribution yield of 6.06% while the competing SPDR fund has a 30-day SEC yield of 5.20% and a dividend yield of 6.56%. A third option in this space and one that has much appeal due to its control for risk is the PowerShares Fundamental High Yield Corporate Bond fund (NYSE:PHB). This fund weights issuers not by total debt outstanding as most of the indexes do (and thus the two funds above) but by fundamental measures such as cash flow, sales, dividends and book value. This makes for a less risky fund but one that also carries a lower yield. If you are comfortable giving up a little bit of the risk, you still get a decent yield as currently the 30-day SEC yield for this fund is 3.55% and the distribution yield is 4.69%.

Another option in the high yield space is a BulletShares series of high yield bonds from Guggenheim. Similar to the corporate bonds mentioned above, the BulletShares High Yield Corporate bonds mature in subsequent years allowing for a laddering effect. This may be another way to play this space, though we would be less inclined to this methodology. Investors probably should not hold high yield bonds once you get past the peak of the business cycle and credit risk is increasing. This is an area best left to more professional players.

Bank Loans - One variation of the high yield theme is a relatively newer space called bank loan funds. Actually there is one ETF in this space that has been around a little while but let me explain what this is all about. Bank loan funds, as their name implies, invest in loans from banks. Technically, these are "floating rate" bonds that are held by these funds. The interest rate on these loans typically reset every 30 - 90 days and is tied to a variable interest rate such as LIBOR or the prime rate. Thus, as interest rates move up, so do the interest rates on these loans. The companies that have these loans are typically more highly leveraged, making them somewhat more risky but these loans are usually secured by first mortgages on property or equipment and these are almost always senior loans so that in the event of a bankruptcy, these would be the first loans paid. You might call these bank loan funds "junk lite." The oldest entrant in this space is the PowerShares Senior Loan fund (NYSE:BKLN). This fund has a 30-day SEC yield of 4.00% and a distribution yield of 4.44%. Another much newer fund (it debuted in April) is the SPDR Blackstone / GSO Senior Loan ETF (NYSEARCA:SRLN). This fund has a 30-day SEC yield of 2.52% but is too new to have a distribution yield. So far, this fund has only had three monthly distributions (May, June and July) so extrapolating a dividend yield is not possible. The SPDR's product is actively managed versus the PowerShares product, which simply follows an index. Whether this active management is worth the additional 35 bps (0.35%) in cost remains to be seen but there can be some arguments for having active management if risk does increase.

Floating Rate - Another area, similar to the bank loan funds above are floating rate bonds. There are a couple of differences between bank loans and floating rate notes. Typically, bank loans are unrated or carry a low debt rating (i.e. "junk" rating) from major rating agencies. This makes them a bit more risky in theory. However, as mentioned above, the bank loans are typically backed by real property. Floating rate bonds, on the other hand, typically carry an investment grade rating from the rating agencies. However, these bonds may or may not be backed by real assets. Sometimes, they are only backed by the full faith and credit of the company issuing them. Lastly, while the bank loans will typically reset in three months or less, floating rate notes may reset less frequently, often on an annual basis and sometimes longer.

There are many funds that have been left out of this list. For example in the short duration space, there are short duration Treasury bond funds and municipal bond funds but these funds typically have a much lower yield due to the lower risk factor than the corporate funds highlighted above. This list is not meant to be exhaustive nor comprehensive. It is merely presented to provide you with some ideas of where to look and how to think about fixed income investing over the next several months. We would encourage you to do your own due diligence on any fund or product you are considering for your own portfolio so that you understand the risks as well as the reasons for purchasing.

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.

Additional disclosure: In the interest of full disclosure, clients of Aerie Capital own shares in the SPDR Barclays Convertible (CWB), SPDR Barclays High Yield (JNK), PowerShares Fundamental High Yield Corporate (PHB) and the PowerShares Senior Loan fund (BKLN).