The rate-sensitive space fell out of investors’ favor to start 2015 as the Fed gave signals of dialing back its low interest rate policies soon. Though the Fed still holds a patient stance on its policy due to unimpressive inflationary numbers and global growth issues, a six and half-year low unemployment data in February and an improvement in wage growth from a tight spot have lately reignited speculations of a rate hike, thereby leading to rising yields.
The U.S. economy generated a total of 297K jobs in February versus estimates of 240K and the prior month’s tally of 239K. The jobless rate slipped to 5.5% from 5.7% recorded in the prior month and from 6.7% in the year-ago month.
Yields on 10-year Treasury notes rose to around 2.24% at the end of March 6 from 2.11% recorded the day before. Plus, the gap between the yields on short-term (2 years) and longer-term (10-years) notes has widened. Not only this, U.S. bond yields spiked to an eight-year high versus its G-7 cousins as investors are apprehensive that the Fed will hike rates sooner than previously expected.
In this backdrop, investors are pulling their money out of the rater-sensitive sector ETFs and bond markets. However, opportunistic investors could capitalize this environment in the form of inverse ETFs.
Inverse ETFs provide opposite exposure that is a multiple (-1x, -2x or -3x) of the performance of the underlying index using various investment strategies, such as, swaps, futures contracts and other derivative instruments.
Investors should note that equity sectors like utilities and real estate are highly rate sensitive as these have high dividend yields and need to depend greatly on borrowings to keep their operations going.
A rising interest rate environment could trouble these sectors as rising rates leave an adverse impact on financing costs. Moreover, the appeal for the high yielding securities wanes when rising rate possibilities take centre stage (read: 3 Sector ETFs to Profit from Rising Rates).
ETFs to Consider
Given the ascent in yields, investors could play the yield-sensitive sectors by taking a short approach to them. This can be done by investing in the following three inverse ETFs – UltraShort Utilities ETF (SDP), ProShares Short Real Estate ETF (REK) and ProShares Short 20+ Year Treasury ETF (TBF).
SDP in Focus
The fund seeks to deliver twice (2x or 200%) the inverse return of the daily performance of the Dow Jones U.S. Utilities Index. The product has $5.9 million in AUM and average trading volume of nearly 5,000 shares per day.
A paltry trading volume results in steep trading costs. The product charges 95 basis points a year in fees, putting it in line with others in the space. Thanks to its double leverage strategy, SDP was up 9.6% last week (as of March 6, 2015).
REK in Focus
This fund seeks to deliver the inverse (or opposite) return of the daily performance of the Dow Jones U.S. Real Estate Index. The ETF makes profits when the real estate stocks decline and becomes suitable for hedging purposes against the fall of these stocks (read: Bet Against Real Estate with These Short REIT ETFs).
The product has amassed over $34.7 million in AUM while volume is light, suggesting additional potential costs in the form of wide bid/ask spread beyond the expense ratio of 0.95%. REK was up 3.4% in the last one week (as of March 6, 2015).
TBF in Focus
TBF is the largest and most popular ETF in the inverse bond space with AUM of $927 million and average daily volume of around one million shares. It seeks to provide 1x inverse (or opposite) exposure to the daily performance of the Barclays U.S. 20+ Year Treasury Bond Index. The fund charges 93 bps in fees. TBF was up 4.6% last week (as of March 6, 2015) (read: 3 Ways to Play Rising Rates with Inverse Treasury ETFs).
As a caveat, investors should note that these products are suitable only for short-term traders as these are rebalanced on a daily basis (see: all the Inverse Bond ETFs here).
Still, for ETF investors who are vigilant over the Fed’s near-term standpoint and are afraid of rising yields, any of the above products could be an intriguing choice. Clearly, a near-term short could be captivating for those with a strong stomach for risks, and believers of the “trend is your friend” philosophy in this investment space.
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