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How To Maintain Income Potential While Betting On Rising Interest Rates

How To Maintain Income Potential While Betting On Rising Interest Rates by Bradley Krom, Fixed Income & Currency, The WisdomTree Blog

Over the last several months, the Federal Reserve (Fed) has continued to reiterate its stance that any shifts in monetary policy will depend on continued improvement in economic data. Over this period, employment data has continued to show signs of improvement, making it increasingly likely that the Fed will finally lift rates on September 17. In the Fed’s opinion,1 it may be only a matter of time until decreases in the employment rate ultimately lead to gains in economic growth and a coincident rise in inflation.

One of the biggest conundrums for investors has been how to prepare for a coming shift in interest rates. Many investors have moved to shorten the duration of their portfolios — thinking long-term interest rates could not remain stuck near historically low levels. While a Fed rate hike is likely the first step, an important determinant of longer-term rates is what usually happens when the Fed starts to allow its balance sheet to shrink. Without the Fed continuing to reinvest the proceeds of maturing securities, the size of its balance sheet would begin to decline, ultimately weighing on the long end. This likely reaction would be primarily due to the disappearance of the Fed as a captive buyer in the market. In our view, exposure to a high-yield debt strategy with negative duration could be one way to accrue income while waiting on rising interest rates.

Return Driver 1: Rising Rates

Typically when interest rates rise, bond prices fall. How much they fall can be approximated through a measure of a security’s duration. The price of a bond with a seven-year duration will fall by approximately 7% for every 1% increase in interest rates. Therefore, if an investor is short a security with a seven-year duration, the investor stands to profit by 7% in the above scenario. While most hypotheticals assume a parallel shift in the yield curve—for example, interest rates rise by 1% across every point—this rarely occurs.

Below, we illustrate this through an examination of the exposures of the WisdomTree BofA Merrill Lynch High Yield Bond Negative Duration Fund (HYND). This strategy invests in high-yield bonds and then shorts Treasury futures contracts in order to achieve a negative-seven-year duration.

Interest Rates

As of 8/14/15 the corresponding SEC 30-Day Yield, distribution yield, and yield to maturity for the Fund are 5.13%, 3.73%, and 6.02%, respectively.

Click here for more complete information about the Fund’s performance.

While the total duration of the portfolio is approximately negative seven years, you can see that it achieves this exposure by selling futures in the 3-7 Years and 10+ Years segments of the yield curve. Therefore, if rates rise only at the short end, the strategy could underperform. But if the yield curve steepens (long rates tend to rise faster than short rates), this portfolio should perform quite well. During the most recent period of rising rates this year,2 this is precisely what occurred.

Return Driver 2: High-Yield Credit

In addition to exposure to interest rate risk, HYND is also exposed to credit risk. In our view, any increase in rates by the Fed should be taken as an endorsement by policy makers that the strength of the U.S. economy is continuing to improve. With the economy strong, the probability that risky borrowers will default should continue to remain low.

As a result, we believe investors can enhance return by assuming additional credit risk. At the portfolio level, the long positions in high-yield bonds help to finance the cost of the short positions. Should credit spreads and nominal interest rates remain unchanged, an investor could potentially accrue income in excess of 3% per year while waiting for the thesis of rising rates to play out.3

So far in 2015, credit has underperformed as commodity prices fell and fears of a Greek...