Plays on Rising Rates

08/06/2004 12:00 am EST

Focus:

William Donoghue

Chairman and Founder, W.E. Donoghue & Co., Inc.

"Consider the Fed's recent 0.25% interest rate hike as a warning shot over the bow for investors," says William Donoghue in a recent report from CBS Marketwatch.com. Here, he looks at funds that will benefit from rising rates.

"Don't go down with the ship. Pull out of fixed-income mutual funds, which are guaranteed to take on water as interest rates rise higher. Long-term government bond funds and zero-coupon bond funds are the most vulnerable in the intermediate term. It's just foolish not to take advantage of inverse bond funds, given the current environment. Face facts: Rising rate trends are everything.

Fact No.1: The market values securities by calculating the net present value of the future benefits (dividends or interest) discounted at a riskless interest rate.

Implications: Rates rise and the 'safest' investments (most credit-worthy) will lose the most market value. Among the worst investments to hold as interest rates rise will be long-term US Treasury bonds, zero-coupon bonds, utility stocks, blue-chip stocks and index funds. The best buy-and-hold investment might be an inverse bond fund or bear market stock fund.

Fact No. 2: Only six out of 541 fund families offer bear market funds. The '99 percenters' refuse to even allow their long-term funds to try to profit from rising interest rate trends. Managers are forbidden by their prospectuses from selling stocks or bonds short, hedging against market risks or 'going to cash'.

Implications: That's nearly a guarantee of principal losses as rates rise. These same funds did nothing to protect your money during the recent three-year bear market in stocks; they promise to do nothing during the coming bear market in bonds and stocks. Dump 'em ASAP or risk losses.

Fact No. 3: Smart money investors are selling long-term government bond exchange-traded funds short by a huge margin. So why are your advisors still counseling, "stay the course?" Are they uninformed or do they simply have no appropriate funds to offer?

Implications: Long funds will almost certainly lose you money. The last time that rates rose like this, 1966 through 1983, the result was a 17-year volatile bear market, during which the market was down 22% and sometimes as much as 40%. This time it will likely be worse. While the stock market rises over time -- it may not rise in time for you.

"Where should you turn? Mutual funds that seek to profit from rising interest rates, falling bond values, and falling stock values are primarily found in three fund families: Rydex Funds, ProFund Advisors, and Potomac Funds. These fund families offer bear market stock funds, which profit as the indexes to which they are linked lose money. For example, Rydex Ursa (RYURX) grows 1% any day the S&P 500 loses 1%. For now, however, your best bet is an inverse bond fund. Each family offers an inverse bond fund tied to a different bond index. Rydex Juno (RYJUX) grows 100% of what the most recent long Treasury bond loses, Rising Rates Opportunity ProFund (RRPIX) earns 125% of the same move, and Potomac ContraBond Fund (PCBDX) makes 200% of what the 10-year Treasury bond loses.

"It's time to think clearly and long term. It's a good bet that interest rates will rise over the next year and inverse bond funds will profit. The greater the rise in rates, the greater the profit. Warning: These funds can be volatile, so plan to ‘stay the course.’ At least the odds are on your side. Duration is the most important measure of risk and opportunity. For example, if interest rates on the most recent long Treasury bond rise one percentage point, Rydex Juno will grow 13.8% in value. But don't put all your eggs in one basket. You might choose to diversify your bets among these fund families' bear market stock funds and inverse bond bonds. Expect a volatile but profitable ride. Frankly, this should be a lot safer than betting your stock and bond funds will protect your money."

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