The path to higher rates has not been a smooth one, but interest rates in the United States are now higher than they have been since the global financial crisis and they may well become higher than they are now. What should traders or investors do about this? How to play it?
One perspective on that big question is offered by WisdomTree, the ETF sponsor and index developer, which has just put out a new blog post on the construction of interest rate hedged portfolios.
It’s Been Five Years
Five years ago, WisdomTree introduced a suite of products addressing uncertainty about rates and about their impact on fixed-income instruments. That was 2013, and the prevailing assumption at the time was that interest rates had to be on the way up, market “tantrums” to the contrary notwithstanding. After all, the Fed had pushed rates down precipitously in the period 2008-09 in response to the global financial crisis. And they had stayed down, at near zero levels, year after year, rewarding consumption and punishing savings. How long can such a policy be sustained?
Many had naturally asked themselves that question by 2013 and had answered themselves “no longer.” So betting on higher rates seemed safe. Indeed, the fact that the dramatic equity market fall late that summer was universally called a “tantrum” testifies to the conviction that the increase of rates was seen, by cooler heads, as inevitable.
And higher rates have come, though the path to them, as WisdomTree says in its new paper, has not been a straight line.
Six and Counting
There have been six increases in the federal funds rate since the introduction of the WisdomTree suite, so the Fed has brought that benchmark up from 0.25 to 1.75. Still, that is far below the historical post-Nixon-float average of 5.73, not to mention the Paul Volcker induced early 1980-81 high point of 20.
Indeed, the general expectation on Wall Street and in Washington is that the Fed will get the fed funds rate to 2.25 by the end of this year, and will make some further increases in 2019.
The U.S. prime rate, that is, the best available rate on corporate loans, generally stays 3 points above the fed funds rate. Accordingly, it is now 4.75%.
WisdomTree continues to believe that “rates remain biased to the upside in the medium term.”
The Best Play
Those fact bring us back to our original question. What’s the best way to play the ongoing increase?
The WisdomTree blog entry begins with a quick reference to floating rate notes (FRNs), which it calls “a traditional approach investors use to combat rising rates.” An FRN is what the name makes it sound like, a note with a variable coupon equal to a reference rate plus a quoted margin.
WisdomTree is happy to report that its rate-hedged aggregate (RHA), the basis of its suite of interest-rate products, outperforms a proxy for FRNs when they are compared to one another for the period of a little more than seventeen quarters beginning December 18, 2013, when the Fed began to taper its balance sheet, and continuing to March 31, 2018. The victory of the RHA can, the paper says, be explained by “shifts in the yield curve combined with compensation for bearing the risk of an imperfect hedge.”
What is the RHA?
So, what exactly is the other side of the comparison? what is the RHA? WisdomTree suggests that investors think of it as two portfolios, one long on a basket of bonds that represent the Bloomberg Barclays US Aggregate Index, Zero Duration. The other portfolio is short on key interest rate exposures across the yield curve. Its cumulative return since the taper has been 6.36%, compared to a cumulative return of 5.47% for the FRN.
The sector weights within the aggregate do fluctuate. But for the most part the sectors mix fixed income securities: Treasuries, corporates, mortgages, and securities products.
WisdomTree offers the usual caveats, such as that “there are no guarantees that our-rate-hedged aggregate strategy will always outperform traditional approaches like” FRNs. And it acknowledges that it has simplified some aspects of the situation considerably in the manner of a blog post, for example ignoring the complexities of bond basis trading.
Still, it concludes that their zero duration indexes “can be powerful tools for investors to deploy as rates continue to rise in the U.S.”