Bear Market Bond Strategies

08/20/2004 12:00 am EST


Marilyn Cohen

President & CEO, Envision Capital Management, Inc.

Marilyn Cohen, president of Envision Capital, has the uncanny ability to turn the complexities of the bond market into easily understandable terms. Here, she looks at fixed income strategies that will provide solid returns in an environment of rising interest rates.

"If we were meeting a year-and-a-half ago, and someone said that oil would be $45 a barrel, the economy would be moving at between a 3.5% and 5% GDP growth rate, the dollar would have declined against the Euro, and the budget deficit would reach half a trillion dollar, you would have probably felt that interest rates would be a lot higher. You would have thought rates would go sky high. But since June of 2003, when the ten-year Treasury hits its low point at 3.11%, rates have only moved back up to 4.4%. With this backdrop most would have expected rates to be 5% to 5.5% and they are not. One of the big reasons why interest rates have remained artificially low is the threat from terrorism. Whenever there has been a threat, Treasury yields have gone down and bond prices have gone up. I also think the Feds are understating inflation by a long shot.

"So how can we survive higher interest rates? Are there bear market strategies that really work? I know it’s hard to believe, but we are in a bear market in bonds. When rates risewhether they are corporate, government, etc. your asset value declines. But the strategies I am going to talk about involve positions that will move up in value when interest rates rise. The key is to look at the things available to you to protect your portfolio as interest rates go sideways to up. The main ways to do this is to buy inverse bond funds that are designed to increase in value when interest rates rise, bank loan funds, floating rate securities, and shorting exchange traded funds.

"First let’s look at Rydex Juno Fund (RYAQX). This fund shorts Treasury bonds, buys put options on Treasury futures, and shorts Treasury futures. So as interest rates go upthat’s your bet in this fund its asset value will rise. They key to a fund like this is to know that it’s not a long-term investment. This should be a trading vehicle only. You want to get in and out as you think interest rates are bottoming and going to move up. They have a family of funds, and you can move into money funds when you think that interest rates are ready to pull back. This is not for small investors. The minimum is $25,000. The next fund has a little bit more octane, but it basically does the same thing. It’s called ProFunds Rising Rates Opportunity Fund (RRPIX). They also short Treasuries, futures, and buy options. But they use leverage and the fund will move 25% more than Rydex Juno. It’s just something to have in your hat if you think rates are going to go up.

"You can also consider exchange traded bond funds to protect against rising rates. You may be familiar with exchange traded stock funds that mimic stock indexes. But there are also fixed-income ETFs. They are very liquid and have very, very low expense ratios. And they cover the whole gamut of what is going on in the bond market. There are iShares Lehman Aggregate (AGG ASE), which is an aggregate bond fund. There are iShares Lehman 1 to 3 year Treasury (SHY ASE), iShares Lehman 7 to 10 year Treasury (IEF ASE), and iShares Lehman 20+ year Treasury (TLT ASE). And there is also the iShares Goldman Sachs InvesTop Corporate (LQD ASE) that represents mostly the upper-tier quality of investment-grade bonds. There is also the iShares Lehman Treasury Inflation Protected Securities (TIP ASE) funds.

"I’m not saying you should buy these for income. I think you should use these if you think interest rates are going to go up. Like Rydex Juno or ProFunds Rising Rates, you can use these ETFs to benefit from a rise in ratesby shorting the exchange traded funds. You can short any and all of them. You don’ t have to worry about waiting for an uptickas you do with stocks when you establish a short position. Just remember, when you are short any kind of bond instrument, you have to pay the interest every quarter or month whatever the situation is. So you want to be in this to hedge, and protect your portfolio, or to speculate.

"If you think Greenspan is ready to accelerate the increase in short-term rates, you would want to be short the iShares that represent one to three years. Because the Fed can only affect short-term interest rates. These are the most sensitive to the Fed’s moves. If you think interest rates are going up a lot, you can short the others. However, I’d note that the performance of the seven-to-ten-year ETF (IEF) since 2002 has been nearly identical to that of the 20 year. I would take a stab and go with ten-year fund. Everything is geared off of the ten-year Treasury mortgages, corporate bond spreads, etc. So if you are think about shorting, that’s the one I would short.

"What if I am wrong? These funds have tons of liquidity, because the hedge funds and the institutions are using these both as trading vehicles on the short and the long side. I would say, if you are going to buy Treasuries, don’t go into a mutual fund. Why have somebody charge you when you can do it yourself. You can use Treasury Direct and nobody charges you. But trading those are much more difficult, if you are trading in any amount under $500,000. So if you want to trade the bond marketeither on the short or long side use the IEF ETF."

"With TIPs funds (Treasury Inflation Protected Securities), your bet is that the CPI will keep rising, because the nominal yieldthe yield you are going to earnis very low. You’re keyed in on inflation. This does not protect you against rising ratesit protects you against rising inflation. I do like them and they help to diversify a portfolio. Having said that, there’s something I like betterthe CPI Linked Corporate Bondswhich are structured differently. TIPs pay you the increase in CPI monthly and it’s added on to the principal of your bond. You don’t get that until you either sell or it matures. And if you buy it outside your tax-deferred account, you have to pay taxes on it as phantom income. If you buy CPI Linked Corporates, you have a similar nominal rate of return about 2% and you get the income monthly. In TIPs you get the phantom income, in the CPI Linked, you get the real cash. I’d much rather have the real cash in my pocket any day of the week. And you can buy them in small quantities. I wouldn’t have a whole portfolio in them, but I would use them to diversify. If inflation gets significantly worse these will do well."

"Finally, I’m going to talk about some specific securities that I like. These specific issues may be hard to find, but I use them to illustrate strategies, and the types of issues you should be looking for if you want individual bonds. One issue I have bought is a preferred stock by JP Morgan. I think JP Morgan is a bank that is too big to fail, no matter how big their derivatives portfolio is. Moody’s rates it A-3. S&P rate it at A-. They call it a stock, but a preferred is really much closer to a bond. It pays interest every quarter. This particular bond was issued back in 1998, so it’s an oldie but a goodie. It’s perpetual, so there is no finite maturity date. When they issued this preferred, they said the stated dividend rate was going to be 4.96% to June of 2003. That was a bad rate in 1999. But the kicker, after that date, was that investors would get the greater of the yield on the three-month, ten-year, or 30-year Treasury less 20 basis points. As a result, when interest rates move up or when short-term rates move up and long-term rates do nothing, you are a big winner. So if the highest rates among the three benchmarks is 5%, then you will make 4.80%. This is called a FRAP (floating rate adjustable preferred). You won’t have to worry about having to lock yourself in to 4.9% if interest rates rise to 9%. These are hard to find, but they are there. These came out at $50 a share and I would still buy them at prices up to $52. You won’t make money on price swings, but you’ll make it on the cash flow.

"Another example of this floating rate strategy is a newly issued preferred from Sallie MaeStudent Home Loan Marketing Association. I really like this, I bought some for all my clients and myself. It’s not that it is such a fabulous rate of return today, but I like it for what it is going to do next year, and hopefully the following year, as interest rates move up. Sallie Mae which is A rated by S&P, is a floating rate bond, with a final maturity of July 2014. Here are the details: You will earn a minimum of 4% for ten years. Rates can go up, or drop to 2%, but you’ll earn 4% at a minimum. With ten-year Treasuries now yielding 4.4%, why would you want to buy this? Because it’s variable. You will earn 80% of the ten-year constant maturity Treasury. I bought this with the thought that interest rates will go up. It may not happen this year or even next year. But they can go up a lot. If rates go up to just 5%, I will still be better off having bought this Sallie Mae. But if rates go up a lot, three, four, or five years down the road, and the ten-year Treasury is at 6% or 7%, then this is a winner versus the ten-year Treasury. I believe this will be a very popular structure. In fact, Sallie Mae recently came out with a another issue with a floor of 4.25%, which is even more attractive than the one I purchased. This type of bond adds a lot of value and captures what I feel is going on in the bond market today."

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