Bollinger: How to Bet on Rising Rates

06/27/2003 12:00 am EST

Focus:

John Bollinger

President and Founder, Bollinger Capital Management

John Bollinger, editor of Capital Growth Letter, is a noted expert in technical and fundamental analysis, covering domestic and international investments. He notes, "The biggest trade of the next couple of years is likely to be shorting the bond market. Given what we know now, the odds are very strong that we will see a substantial increase in interest rates and a substantial decrease in bond prices. How can one take advantage of this opportunity? There are a myriad of ways." Here he explains.

"One can short the T-bond, T-note, or similar futures contracts. One can purchase inverse mutual funds--the Rydex Juno Fund (RYJUX) or the ProFunds Rising Rates Opportunity Fund (RRPIX )--that go up when interest rates go up. For the sophisticated professional investor who understands such things there are mortgage derivatives called IOs, short for interest only, that become more valuable as rates rise. Then there are a wide variety of interest rate options, both listed and over-the-counter. Finally, there are step-up notes and other types of structured notes that offer advantages when rates rise.

"As you can see there are plenty of opportunities to play the downside of bonds or the upside of interest rates ranging from the quite conservative to the very risky. So virtually any investor can put together a program to protect their portfolio and every speculator can potentially profit handsomely when rates rise. We aren't really ready to put this trade on yet, but we plan to make a substantial commitment to this idea in the foreseeable future. So to prepare for the opportunity, here are some thumbnail sketches of what is available.

"Futures: There are futures contracts traded on the Chicago Board of Trade on two-, five-, ten-, and 30-year government notes and bonds. These are extremely liquid and offer a direct and leveraged opportunity to participate in these markets. There are lots of things to think about when trading these: The yield curve, cheapest to deliver and rollovers to maintain your position are a few of the issues. You'll need an experienced and knowledgeable professional broker to work with.

"Mutual funds: There are only two that I know of that move directly opposite rates. Juno targets the inverse of the current benchmark long Treasury bond, while Rising Rates Opportunity Fund targets 125% of the inverse of the same bond. Of course there are many contrarian funds that might work, but they don't offer direct positive exposure to rising rates.

"Mortgage derivatives: Mortgages can be stripped into two components, the interest payments and the principal payments, IOs and POs. POs do well when interest rates decline and IOs do well when rates rise. Both of these can become ugly quickly if you are on the wrong side of the equation, but if you are right they can reward handsomely. As with futures, experience is the name of game. A very experienced broker with in-depth knowledge is an absolute must as is a thorough understanding of the risks. Remember, mortgage derivatives brought Kidder Peabody and Piper Jaffrey to their knees, so buyers beware.

"Options: There are many types of interest rate options from simple bets on the direction of rates to the most complex structures imaginable. The Chicago Board Option Exchange offers call and put options on 13-week Treasury bill, five- and ten-year Treasury note and 30-year Treasury bond rates. The symbols are IRX, FVX, TNX, and TYX, respectively. The strike prices are the interest rate times 100, 4.5% = 45. These are not the most liquid contracts and the spreads between bid and asked prices are atrociously wide, but they might be worth a look. There are many interest rate options including the very popular and highly liquid options on interest-rate futures.

"Structured Notes: There is hardly such a thing as a simple note or bond anymore. Today notes come with all kinds of calls and puts, changing coupons and many other diverse features. If one is looking for interest rates to rise a callable step-up note might be just the thing. It starts with a low coupon and at some point the coupon rises dramatically, usually accompanied by a call. So if rates remain low, the note will be called and you will get your money back when the coupon rises (or before), but if rates have risen to above the issuer’s funding cost after the coupon increase you'll be left with the full-term, higher-coupon note. (These notes are often issued by Fannie Mae and Freddie Mac.)

"We will use a mutual fund in the core portfolio to track our commitment to (defend against) rising rates. However as noted above, there are a wide variety of choices available to construct a position of any type from a very conservative hedge to an aggressive speculation in response to the very high probability that rates will rise."

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