The Build America Bond ETF and Interest Rates

| About: PowerShares Build (BAB)

On Monday, the folks at Powershares sent around an ETF report that included a lot of information on their new Build America Bond ETF (NYSEARCA:BAB). As I have mentioned before, I am favorably disposed to the segment and the fund but do think that, at a minimum, it needs a few months of trading under its belt before I would be comfortable buying some.

In the report, there was a table of correlations to other asset classes and other bond market segments. A crucial element of portfolio construction is the interaction of one thing with the other things in the portfolio. Part of this understanding comes from looking under the hood (if we are talking about an ETF), but some must also come from observing actual trading. It is OK to give a fund a few months to build a little track record without you. The fund will still be there in six months.

Chances are the numbers in the table are not a shock to anyone, but it is still instructive. It has a 0.89 correlation to ten year treasuries, and it looks as though the index underlying BAB yields quite a bit more than the ten year, however.

This serves as a warning of sorts. Even after a noticeable move up in rates in the last few days, 3.68% is a very low number by historical standards. Additionally the current environment of debt issuance creates a visible path to higher rates.

The above does not ensure higher rates; it just creates visibility. If ten year treasury rates do go up then the prices will go down and based on the history of the index underlying BAB so too will build America bonds. As a rule of thumb, an 100 basis point increase in yield works out to about an 8% drop in price, though obviously it could be a little more or a little less with an ETF. The difference with an ETF is there is no par value to collect at maturity.

According to Yahoo Finance, the ten year yielded 6% or more the vast majority of the time from 1969 to 1997. Although Yahoo Finance does not go back past 1962, yields were generally lower than 6% most of the time before that in the 20th century.

You can decide for yourself what normal is, whether rates are going higher or not and if they do go up how much, but it should be clear that if rates go up BAB will feel that pain. Owning BAB means believing rates will not go up or being willing to actively follow the interest rate market and being willing to take action of some sort if rates do start to rise in a meaningful way.

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