Interest Rates continue to test our patience!

by Wayne Ferbert on May 1st, 2012

I found an article today on Barron's that I thought best captured the investor sentiment for interest rates and investing in Fixed Income. In the Income Investing blog on Barrons, the post had the following quote:

"Rates are ridiculously low, but they could still go lower, but in the long term they’re likely to go up. The key question is when any of this will happen. Your guess is as good as mine, but if you get it right you’re going to make money, and if you get it wrong you can lose money."

You might recall that it was a very popular bet among hedge funds in 2011 to short Treasuries - expecting the rates to go up last year. It not only didn't materialize, but Treasuries rallied and the shorts got killed. 

How many years are we gonna sit back and be skeptical that rates can go any lower? You can place me squarely in the camp that believes interest rates have to go back up - and that it will likely start in less than 12 months. But I also said that a year ago. These low rates are un-precedented.

As a fixed income investor that likes to use ETFs, it makes the analysis of maturities and duration for the ETFs very important. You can always purchase individual bonds and hold them to maturity - so when rates go back up, the loss on the bond is just on paper. You will hold to maturity and watch the price make its way back to par. But in that scenario, you have more concentrated credit risk in whatever entity issued the bond.

In the fixed income ETF, you have your credit risk spread out over many entities - but your duration will be managed to a target number by the ETF manager. The ETF implements regular buying and selling in a laddered program inside the ETF to get to the target duration. The result: interest rates will cause the price fluctuation to be felt in the ETF price - the longer the duration, the higher the price fluctuation.

It makes the ETF investing game for fixed income a little more complicated. So, it means a few things to the Buy & Hedge investor:
1. Hedge your fixed income ETFs a little tighter - as rate increases will cause the ETF prices to decline
2. Make sure your downside protection on the fixed income ETFs is laddered - because you don't want to be guessing when the rate changes will occur. The ladder will cover many expirations for you.
3. Avoid any ETFs that trade at any premium of any kind - in other words, invest in only the large ones with lots of volume

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