What Will Get Hit Worst When Rates Rise
Summary John Authers argues the assets that will be worst affected by the Fed raising rates are ones paradoxically considered lower risk. These assets are high quality corporate bonds and municipal bonds, particularly those of longer duration. We highlight two bond ETFs that may fit those criteria and offer ways for investors to limit their risk. The Paradox Of Risk In his Long View column in Saturday’s Financial Times (“Dress rehearsals set stage for how assets will react to rate rise”), John Authers pointed out a paradox of risk: Generally, risks are greatest when there are not perceived. People who have bought a security believing it to be high-risk tend to guard themselves against the risk; those who think they have a low-risk investment do not. This could therefore amplify the chance of a full-blown financial “accident.” The putatively low-risk assets Authers has in mind are bonds, specifically higher-quality corporate and municipal bonds of longer duration, and the threat he sees is of the Fed raising rates. How Rising Rates will Hit High Quality Corporates and Munis Although Authers thinks a rate rise this week is unlikely, he sketches out the potential consequences of an eventual series of rate hikes: Higher target rates set by the Fed will send bond yields higher, which means bond prices must go down. With yields already low, the proportionate falls in prices need to be that much greater. Why would high-quality corporate bonds and munis fare worse than other types of bonds? Authers believes that Treasuries will benefit from a flight-to-quality in the event of a rate rise, and junk bonds will be less sensitive to interest rates because they carry greater credit risk. That leaves higher quality corporate bonds and municipal bonds. Authers notes a difference in market structure for bonds that makes the credit market “lumpier” than the stock market: rather than trading on an exchange, most bonds are sold through dealers; and since banks have, since the financial crisis, cut back on the capital they allow their dealers to spend on bonds, there may be fewer institutional buyers to support flagging bond prices. Duration and Interest Rates Bonds vary in their sensitivity to interest rate movements according to factors including their time to maturity. The finance term used to express interest rate sensitivity is duration, and it is expressed as a number of years. The longer a bond’s (or bond ETF’s) duration, the more sensitive it will be to interest rate movements. Two Bond ETFs that May Be at Risk In his column, Authers warned about longer duration bonds, but didn’t quantify what he meant by longer duration. According to Fidelity though, the average duration for fixed income ETFs is 4.43 years. Two ETFs that invest in high quality corporate bonds and municipal bonds, respectively, and have effective durations higher than that are the iShares National AMT-Free Muni Bond ETF (NYSEARCA: MUB ) and the iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSEARCA: LQD ). Both ETFs invest in higher quality bonds. According to its fact sheet , only 0.04% of MUB’s bonds are non-investment grade (BB-rated). The rest are BBB-rated (1.25%), A-rated (28.89%), AA-rated (48.81%) or AAA-rated (21.82%). Its effective duration is 4.75 years. According to LQD’s fact sheet , the bulk of its bonds are either BBB-rated (39.52%) or A-rated (47.68%). The rest are AA-rated (10.8%) or AAA-rated (1.7%). Its effective duration is 8.04 years. Ways For ETF Investors To Limit Their Risk If you own these ETFs, agree with Authers’ thesis, and expect a rate rise sometime in the next several months, there are a couple of ways you can limit your risk. The simplest way is to sell them. If you’d rather not keep your money in cash after selling them, we looked at a low-risk alternative to cash in a recent article (“An Alternative to Cash for a Risk-Averse Investor). Another way to limit your risk if you own these ETFs is to hedge them. You can hedge them by buying optimal puts on the ETFs to limit your downside risk. Puts (short for put options) are contracts that give you the right to sell a security for a specified price (the strike price) before a specified date (the expiration date). Optimal puts are the ones that will give you the level of protection you are looking for at the lowest cost. This page offers more detail on how optimal puts can limit your downside risk. Below are sample hedges for both of the ETFs we’ve discussed here. Hedging LQD against a > 15% decline by March 17th These were the optimal puts, as of Friday’s close, to hedge 1000 shares of LQD against a greater than 15% drop between now and March 17th. As you can see at the bottom of the screen capture above, the cost of this protection, as a percentage of position value, was 0.56%. Note that, to be conservative, this cost was calculated using the ask price of the put options. In practice, you can often purchase put options for less, at some point between the bid and the ask prices. Hedging MUB against a > 15% decline by February 18th These were the optimal puts, as of Friday’s close, to hedge MUB against a greater-than-15% decline between now and February 18th. The cost of protection for the MUB hedge above is 0.41% of position value (calculated in the same conservative manner as above for LQD). It’s not surprising that the LQD hedge is a little more expensive; all else equal, you’d expect it to be a little more expensive because it expires a month later than the MUB hedge. What’s a bit surprising is that it’s not more expensive relative to MUB, given LQD’s lower average credit quality and its significantly higher effective duration. Perhaps the answer is in the paradox of risk offered by Authers: most LQD investors don’t see it as a risky investment, so they haven’t bid up the cost of hedging it. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) 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.