RISE: Protection Against Rising Rates

02/26/2016 10:00 am EST

Focus: ETFs

The Sit Rising Rate ETF is designed to act like an insurance policy protecting bond investors against rising interest rates. Here, we talk with portfolio manager Bryce Doty, who explains how the fund operates and how it can benefit your overall portfolio.

Steven Halpern:  Our special guest today is Bryce Doty, portfolio manager of the Sit Rising Rate ETF (RISE). How are you doing today, Bryce?

Bryce Doty:  I'm doing well. Thank you for having me.

Steven Halpern:  I thank you for taking the time. Bonds have typically been considered a safe haven for investors, but in today's environment you suggest that investors need to take a more cautious approach. Could you expand on that?

Bryce Doty:  That's correct. Bonds typically have been the portion of your portfolio that provides stability. However, as interest rates have become increasingly volatile, bond portfolios are no longer providing that same degree of safety that they had over the recent years at least.  

On one hand, we are dealing with the Fed’s raising rates, and then on the other hand, we see days when the price of oil drops suddenly and that in turn spooks stock markets, which results in a flight equality that's actually pushing yields lower.

So we're seeing this whip sign of yield that is causing a lot of volatility in the underlying value of most traditional bond portfolios.  Consequently, you find yourself in a bond market where it actually pays to protect.  

While it used to be worth it to take a little extra risk to earn a little extra income, now you're rewarded more for giving up a bit of income in order to preserve what you have.

Steven Halpern:  Now, the Sit Rising Rate ETF is specifically designed to help protect traditional bond portfolios from a rising rate policy.  Could you explain how this ETF works?

Bryce Doty:  Yes, we first designed our rising interest rate strategy nearly four years ago after listening to our institutional investors and their concerns about what was going to happen to their bond portfolios when interest rates did rise.  

A year ago, we launched that same strategy at the ETF RISE and, as you know, the higher yields become for newly created bonds, the less attractive the bonds in your existing portfolio will look by comparison.

So, conceptually, this is why bond portfolios lose money when rates rise, and the longer you have to wait to be paid back on your bonds before you can reinvest at the higher yield, the worse it's going to be.  

Our strategy is designed to actually go up in value when yields rise.  We accomplish this by primarily shorting two- and five-year maturity treasury futures contracts, and since we are shorting bonds, rise is going to move in the opposite direction of traditional bonds.

Just as a simple example of how shorting works, imagine borrowing something from your neighbor for a couple months, then going and selling it knowing you're going to need to buy it back later.  

If you borrowed a bond and sold it for $100 and then interest rates rise, you might be able to buy that bond back for only, let's say, $95 and keep that $5 difference, thereby making money when interest rates rise rather than losing money.  

Now the reason we focus on two- and five-year bonds is because their yields are typically reacting the most to a change in Fed policy.  

Steven Halpern:  Now you feel that a position in this fund can act as what you call “collision insurance.”  Could you explain what you mean by that?

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Bryce Doty:  Right. We think of rises as a form of bond insurance. Moving a portion of your bond portfolio into RISE can provide a lot of protection.

Depending on your bond portfolio, just a 15% to 20% allocation could cut in half your underlying risk to rising interest rates.

Like all insurance, there is a cost, but a rough rule of thumb that I've used is that you can cut your interest rate risk nearly in half for about a one percentage point reduction in the overall yield.

And we have a simplified calculator on the home page of the Web site at RisingRateETF.com that investors can actually use to determine the precise impact or an estimated impact on the bond portfolios for varying amounts that they would want to allocate to RISE.

And finally, like collision insurance, you like to have it in place before the accident happens or in this case before the fed raises rates again.  

Steven Halpern:  Now the Sit Rising Rate ETF has a negative 10-year duration.  Could you explain what that means?

Bryce Doty:  Sure, let me begin with how the concept of duration is used to estimate how much the price of a bond is expected to move when interest rates move—let’s say a full percentage point—and the calculation ignores interest income and expenses and just focuses on the change in price.  

For example, if a bond has a positive duration of let's say five years, and interest rates rose from 1% to 2%, the bond would decline about 5% in value, whatever its duration is would be the % decline in value.

A negative duration indicates that the value will rise instead of fall when interest rates move up, so with a negative duration of 10 years, RISE is expected to go up in value by nearly 10% when interest rates rise by a full percentage point. Consequently, in the case of RISE, a little goes a long way.

Steven Halpern:  Now, before we let you go, we've only got a minute left, but you're also the senior fixed income manager at Sit Investment Associates.  Could you tell our listeners a brief bit about your firm?

Bryce Doty:  Sure, our firm was founded by the Sit family and is currently employee-owned.  We're based in chilly Minneapolis, Minnesota.  We manage 14 billion in stocks and bonds for both large institutional entities, as well as individual investors.  

I've been the head of the taxable bond group for the past 20 years and our group manages about $6 billion of the $14 billion, and since the firm has been around for 34 years, a number of my colleagues have actually been here longer than me. Lastly, we're proud to have just been named the best fund family for 2015 by Barron’s.

Steven Halpern:  Well, congratulations, and again, our guest is Bryce Doty of Sit Rising Rate ETF.  Thank you so much for your time today.

Bryce Doty: Thank you.

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