Protecting against rising interest rates

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Jun 29, 2010 8:37 am

What are you advisors currently doing to protect against rising interest rates? Is anyone using a specific fund or ETF?

Also I simply ladder my fixed income but lately I do not know what to sell for the short term side of things, what are folks using there?

Jun 29, 2010 9:18 am

I use the same laddering strategy for 1-5 years and then sprinkle in TIPs bonds 6-12 years.  Just be careful in taxable accounts due to the phantom income.  Over 12 years I have been using GO BABs up to 20 years.  Nothing longer though.

Jun 30, 2010 8:48 am

The worry I have had with TIPS is that they do not pay much and I am concerned that rising interest rates doesn't necessarily mean a rise in the CPI.

Could you explain the phantom income tax? Is that like taxes on zero coupons?

Jun 30, 2010 10:05 am

It is similar to zeros.  The value of the bond increases with the rate of inflation.  The principal amount of the bond will move up (or down) with the rate of inflation.  That's the phantom income.  So if it goes up the holder has to pay tax on that amount eventhough they do not actually receive the interest until maturity.  TIPs are a nitch investment...I like them for small percentages in IRAs, people that have too little in equities and people not using the interest they make on CDs.  Hope that helps.

Jun 30, 2010 12:51 pm

Great info. My concern now is finding an income alternative to a CD for the 70+, 80+, even some 90+ crowd. And I don't want to be in the CD business. If I'm going to starve to death, I don't want to do it in an office.

Jun 30, 2010 10:04 pm

Also, on the individual bond side if someone doesn't need income now zero t/f munis in a taxable and zero BABs in and IRA are attractive.

Jul 1, 2010 10:32 am

Question: Why do we need to protect against rising interest rates?

Jul 1, 2010 11:14 am

[quote=RealWorld]

What are you advisors currently doing to protect against rising interest rates? Is anyone using a specific fund or ETF?

Also I simply ladder my fixed income but lately I do not know what to sell for the short term side of things, what are folks using there?

[/quote]

Which rates are rising?  Also, if you are laddering, I assume it's for income, so why the worry about rising rates?  Maturing bonds will be re-invested at higher rates. 

Jul 1, 2010 11:50 am

I literally don't want to have the discussion about if interest rates are going to rise or not. The reason why I need to worry about fixed income rates is that I have a lot of clients who say they own the bonds for income but in 08 when they saw the values go to 75% they freaked out. Maybe it is because I don't have a 20 yr relationship with them like Bondguy.

How I built my business wasn't really on selling short term bond funds, it started with hi ___ I have a good fixed rate on a safe investment. blah blah. The person opened an account and gave me 20K for the bond, now I am retalking to those folks about the ladder.

Jul 1, 2010 12:30 pm

Realworld, My question wasn't posted to put you on the defensive. No need to defend  your reasoning or to discuss whether or not rates are going to rise. Your reasoning is your business and rates will rise, only a question of when.

My question goes to over thinking it. And, thus overmanaging accounts. Rates will cycle up and down as we move through an economic cycle. The ship changes direction several times over the course of a voyage. Why move the deck chair if the ship is going to change direction in a short time to put you back into the sun?A lot of work for little if any gain for the long run. And, in fact, when it comes to bonds possibly and most likely a big loss of income. It seems to me, for the long term income buyer, there is little to be gained from inflation/rate hedging.

As for the hit from 08, yeah, that hurt. Yet since that time, with the exception of certain sectors of high yield, bonds have mostly recovered that lost value. And, 08 had nothing to do with interest rates. It was all about trust. Add to that the fact that even at 75% of par value, those bonds made their coupon payments.

Those being the facts, is it really necessary to give up income to hedge what is most likely to be only a temporary paper loss? Thus my question: Why do we need to protect against rising interest rates?

Jul 1, 2010 1:01 pm

BG, great comments, thanks.

Jul 1, 2010 2:01 pm

RW,

This is what I have done with clients: for clients with large allocations to fixed income (many), I sat them down AGAIN and explained EXACTLY what IS going to happen.  Not what MAY happen, but what WILL happen.  Rates WILL rise, bond prices WILL FALL.  THESE ARE OUR OPTIONS......(go on to explain duration in layman terms, income vs. face value, short term vs. long term and the implications, moving to stocks, moving to shorter term, etc.).  Basically I let them know that their bonds WILL lose principle value, but that the change in face value is a mirage if they don't plan to sell.  I also make it clear what the implications are of changing strategy (going to cash, CD's, etc.) on their income. 

I have found that OVER-communicating with clients helps.  Making sure they understand EXACTLY what is likely to happen (but not trying to "predict" when and by how much) helps prepare them mentally, to the point that when it happens, it's no big deal.  By doing this, they get the feeling that you really know what you're doing, without giving any sense that you can forecast the markets.

Jul 1, 2010 6:19 pm

[quote=BondGuy]

Realworld, My question wasn't posted to put you on the defensive. No need to defend  your reasoning or to discuss whether or not rates are going to rise. Your reasoning is your business and rates will rise, only a question of when.

My question goes to over thinking it. And, thus overmanaging accounts. Rates will cycle up and down as we move through an economic cycle. The ship changes direction several times over the course of a voyage. Why move the deck chair if the ship is going to change direction in a short time to put you back into the sun?A lot of work for little if any gain for the long run. And, in fact, when it comes to bonds possibly and most likely a big loss of income. It seems to me, for the long term income buyer, there is little to be gained from inflation/rate hedging.

As for the hit from 08, yeah, that hurt. Yet since that time, with the exception of certain sectors of high yield, bonds have mostly recovered that lost value. And, 08 had nothing to do with interest rates. It was all about trust. Add to that the fact that even at 75% of par value, those bonds made their coupon payments.

Those being the facts, is it really necessary to give up income to hedge what is most likely to be only a temporary paper loss? Thus my question: Why do we need to protect against rising interest rates?

[/quote]

You are not serious are you?  Rates have one place to go from here.  UP.  This is not a normalized rate market and to act as though it is, is foolish.  Hedge with TIPs, ladder bonds, equities, and short duration funds.  There is no magic.

Jul 1, 2010 7:33 pm

Ok Jump, question: How high are rates going to go from here?

I ask because from a long term income buyer's POV, while you're down screwing around on the short end getting what, all of 2%, I'm knocking down 6 and 7% on long end BABs. Throw in some Step-ups yielding north of 5% and I gotta ask, why hedge? If rates increase the BABs will lose some value, true enough. But, you know,  my house lost value over the last two years. And the response from me is; so what! I'm not moving , it doesn't matter.

On a side by side comparison, on an income level, the hedged portfolio will never catch up to the non hedged portfolio. And, if you are right about rates not being normalized, i say that because i admit i'm not smart enough to know, we have an ace in the hole to bail us out of principle loss hell, Maturity! Bonds mature at par. Since we were planning on holding the bonds until maturity anyway it kinda works out just fine regardless of what rates do. So, to answer your question, I'm serious.

Now, if you're buying bonds as part of some asset allocation program hedge to your heart's content.

Jul 1, 2010 8:27 pm

Great answer again BG. It seems like a lot of FA's are concerned with principal loss and are willing to give up return in order to hedge against said loss. Buy if a client is needing income, TIPS etc just won't work and you get taxed on the step up. As long as customers have a long term view, a good bond ladder offers real value. Yet, in spite of your great previous explanation, I am still a bit worried about premium bonds. I won't belabor that point but folks have gotten real nervous and worry whenever their portfolio shows a loss. I don't know..I'm just real nervous about the market right now and if we double dip(or are we up to triple dip, I lost count) it's going to be hell getting people to invest at all.

Jul 1, 2010 8:44 pm

To buy into long positions in the lowest rate market is silly.  No need to quote the coupon you are getting - we all see the same stuff.  It's not the point, interest rates have one way to go from here.  One way.  Do you disagree? Do you recall rates locked at this rate before?

Knowing what we know selling long term paper for anything but income is suicide. You'll get no argument from me about the income argument but let's face it, most advisors use bonds to hedge against downturns.  Perhaps not you but your advice is dangerous for anything but income.

Jul 1, 2010 9:31 pm

Jump, I don't think we disagree on hedging for allocation purposes. A hedge should be on regardless of the rate cycle. As for the rest "I know nothing, I assume nothing." What i do know is that even with T's at near all time low rates the credit spread is still too wide in some key markets. Fear is driving that train. So, for income buyers an opportunity. And, if that turns out not to be true, well, they get exactly what they signed up for; a coupon payment every six months that gives them a yearly income that matches the S&P 500's return over the last 45 years.

 And, the question still stands: How high do rates have to go to make LT bonds a bad investment? over what time period and how will the cycle back affect prices? Everyday that rates stay where they are or do what they've done lately, the hedged portfolio loses ground to the LT portfolio on an income basis. How does one justify the lost income?

Buy the way, income buyers are what i'm talking about. Whenever you see me post about the bond market that's the POV I'm coming from. That's important because it means we're not constantly fiddling with the portfolio as we go through an economic cycle. No messy forcasting to worry about. The loses caused by rising rates are paper loses. Just as the gains by lower rates are paper gains. We hold LT unless a benefical swap op comes along. And the thing about being income/bond experts instead of Wealth Managers is we can find those opportunites. So, while the Wealth Management gurus are busy micro macroing everything to death so that the client will have capital preserved to develope an income , we're busy driving that income to the bottom line. How simple is that? Too simple to charge a fee for which why Wall Street doesn't push it.

Navet, as I've said Premium bonds can act as a hedge against inflation. The premium is repaid through the higher coupon payments. The worst that can happen to a client who owns a premium bond, regardless of what the markets do, is getting par back at maturity. I know, low IQ. But true.

Jul 1, 2010 9:35 pm

Tell that to the Japanese jumpman! 

Jul 1, 2010 11:36 pm

I hear you BG. Thanks.

Jul 2, 2010 8:32 am

Ice, my ROA is just over 60 beeps. Which is on the very low side for my side of the biz.

I'm lost on the RIA thing. Once you get me past what RIA stands for i'm clueless.

But everything you said sounds cool!

Can all that be done?