A Bond ETF Investing Playbook to Profit From Rising Interest Rates

Includes: EDD, EMB, TBF, TBT
by: Daniel Moser
Bill Gross, the famed bond manager, in his January 2011 Investment Outlook commentary titled “Off With Our Heads” provides an ample amount of topics and insights worth considering while determining an individual's optimal asset allocation. While others on Seeking Alpha have discussed this commentary, I would like to focus in on a couple of particular items discussed: credit risk and interest rate risk.
Right up front, it must be mentioned that Bill Gross paints a grim picture of the U.S. economic situation and quite frankly, I believe it is rather difficult to disagree with much of what he argues. One of the key points Mr. Gross makes is that “Currently, the Fed is doing both, holding short term interest rates near zero, and engaging in Ponzi like Quantitative Easing II purchases of longer dated Treasuries in the open market. The combination offers bondholders about as an attractive situation as the one facing a male praying mantis: zero percent interest rates if you stay in cash, or probable principal losses if you take durational risk by buying 5 and 10 year maturities. Eventually, as reflationary policies take hold, long-term bondholders lose their heads (and a portion of their principal as well), as yields rise to reflect higher future inflation. Bondholders’ metaphorical warning: 'don’t go near those longer term bonds you fool'.”
It appears that a majority of market strategists believe that interest rates, on a medium and/or long term time horizon, have one direction to go: up. Every so often there is someone brave enough to present and defend a contrarian perspective. However, from my vantage point, the contrarians only seem to be contrarian in so far as they believe that interest rates will remain low for a while longer than the majority of market seems to think. The contrarian point of view seems to concede that interest rates will increase in the future…they just disagree on when the “future” is. The interest rate contrarians would argue that there is still some opportunity to earn some profit by surfing the yield curve.
However Bill Gross refutes this perspective when he argues, “An astute mantis-like investor must defer immediate gratification, make a 180 [degree] turn from that sexy looking female with those long green legs (long term bonds) and mend his ways fast! It is still possible to earn an attractive return from bond strategies (such as PIMCO’s Total Return strategy in 2010), and the way to do it is to focus on “safe spread” that emphasizes credit, as opposed to durational risk.”
Mr. Gross suggests that “these 'safe spreads' include emerging market corporate and sovereign bonds with higher initial real interest rates and wider credit spreads; floating as opposed to fixed interest obligations, and importantly currency exposure other than the dollar.” Naturally one must wonder, "how can an individual investor position themselves to capture some of these insights offered by Bill Gross?"
First (and possibly most obvious): an investor can invest in the PIMCO Total Return fund which is managed by Bill Gross. To a large extent, it seems fair to suggest that Bill Gross manages this fund to reasonably conform to his investment views and insights albeit remaining with in the fund mandates – and that should naturally include managing the risk of the fund to avoid areas in which he believes investors are not adequately compensated for risks assumed.
Secondly, my interpretation of Bill Gross’ outlook is that credit risk is far better than interest rate risk. As a result emerging market debt is one of the primary opportunities for investors. There are several ETF’s that capture emerging market debt exposure. BUT there are also numerous Closed-End funds that are even potentially better than the ETF’s. One such fund is the Morgan Stanley Emerging Market Domestic Debt fund (NYSE:EDD). EDD does have substantially higher fees but it offers a higher yield and a more concentrated portfolio. The portfolio’s heavily weighted as follows.

The iShares emerging market debt fund (NYSEARCA:EMB) is fairly different from the Closed-End Fund:

While the two funds hold the same essentially the same top concentrations (excluding Russia) their overall level of concentration is quite a bit different. The iShares fund holds a tiny amount of practically everything, whereas the Morgan Stanley fund has no doubt taken a market view. In terms of expressing a view on credit, I believe EDD is a superior way for individuals to express a constructive view on emerging market credit risk–despite the higher fees. There are numerous other ETFs and closed-end funds that can be utilized to gain exposure to emerging market credit thus the takeaway is not that these two funds are the “best” funds to express a view on emerging market credit…these are just two examples of funds that can be used to express this view.
Finally, and perhaps most importantly, how can individuals easily (relatively speaking) take advantage of rising interest rates? The Apple marketers say, “there’s an app for that", well if an individual wants to gain exposure to rising interest rates, "there's a fund for that”. There are quite a few floating rate closed-end funds (which seem to go by the name "loan participation funds") in existence that should prosper in a rising rate environment. It must be noted that these funds seem to incorporate a substantial amount of credit risk as well as floating interest rate exposure.

A more complete list of these funds can be found at the following link: http://www.closed-endfunds.com/default.fs.
Additional options include the Proshares ETF’s aimed at capturing value during a rising rate environment: TBF(NYSEARCA:TBF) and TBT (NYSEARCA:TBT). The TBF fund is designed to track (hopefully) 100 percent of the inverse daily returns of the Barclays Capital 20+ Year U.S. Treasury Index. The other fund, TBT, is designed to track 200 percent of the inverse of the Barclays 20+ Year Treasury Index. It is absolutely critical to note that tracking error can and does occur and it is particularly egregious on the double leveraged funds just like TBT. For this reason I would advocate avoiding funds like TBT simply because an investor can make the medium and long term call correct and still lose money because of volatility and the nature of compounding in the interim period AND the way the double leveraged funds are designed. TBF will probably experience some degree of tracking error over a longer holding period as well…but it will be far less than TBT.
My take: Some people might argue about the timing of increasing interest rates but few can build a case that they will remain low or decline from present levels over a medium or long time horizon. Bill Gross is a quite simply an expert on practically all things fixed income related and, as such, individuals would probably, more often than not, do well to heed his advice. Between the PIMCO Total Return fund, EDD, one or more of the floating rate closed-end funds on the list shown above, and TBF…individuals have of quite a bit of opportunity to make strategic investments to capture value from assuming some credit risk and risk exposure to rising interest rates.

Good luck and thanks for reading.

The PIMCO Investment Outlook Jan-11 can be seen using the following link:

Disclosure: I am long EDD, TBF.

Additional disclosure: I also have a long position in the PIMCO Total Return Fund.