After closing its asset repurchase program in October 2014 and hiking interest rates thrice from December 2015 to March 2017, the Fed is now on its way to reduce its $4.5-trillion balance sheet as soon as this year (read: Doves Turn Hawks: 5 Fed-Proof Bond ETFs to Buy).
Economists expected the U.S. central bank to start lowering bond exposure from its portfolio sometime next year. The economic well-being led Fed members to decide on the move. No timetable has been disclosed yet.
The Fed announced three rounds of “quantitative easing" or QE from 2008 through 2012, buying mostly long-term Treasuries and mortgage backed securities and beefing up its portfolio. The move was aimed at goading economic activity.
Till now, the bank has been reinvesting the proceeds from these bonds and rolling them over instead of reducing the size of the balance sheet. However, it is yet unclear how the Fed will implement its reverse QE move. It may end reinvestments of all or slowly weed them out.
Impact of Reverse QE
Whatever the case, bond yields are likely to increase from such moves. Though yield on the 10-year U.S. Treasury note dropped 2 bps to 2.34% on April 5, 2017 after the Fed minutes hinted at reverse QE from the day earlier, short-term bond yields actually gained. Both three-month and six-month bond yields gained by 1-bp each on April 5, 2017 from the previous day.
Prospects of the materialization of some of Donald Trump’s pro-growth agenda are now in a questionable spot, especially after the failure of the Health Care bill. Plus, the highly watched out meeting between Trump and Chinese president Xi Jinping have probably kept Wall Street on edge, which is why stocks moved lower, pushing up safe-haven bets like benchmark U.S. Treasuries.
As per Market Watch, “traders did not think the minutes were hawkish enough,” which probably led the benchmark U.S. Treasury yield to decline.
Is Steepening of the Yield Curve Likely?
If everything remains sturdy on the global economic front and no geopolitical crisis flares up causing a safe haven rally, long-term interest rates should go up from a reverse QE. In fact, mortgage and other rates are expected to go up faster than investors’ expectations.
On the other hand, the Fed may stay away from a steeper short-term rate hike trajectory if it starts unwinding bond holdings alongside. This scenario would result in steepening of the yield curve.
Given this, investors must be interested in finding out all possible strategies to weather a sudden jump in interest rates. For them, below we highlighted a few investing tricks that could gift investors with gains in a rising rate environment.
Go Short with Rate-Sensitive Sectors
Needless to say, sectors that perform well in a low interest rate environment and offer higher yield, may falter when rates rise. Since real estate and utilities are such sectors, it is better to go for inverse REIT or utility ETFs. ProShares Short Real Estate REK and ProShares UltraShort Utilities SDP are such inverse ETFs that could be wining bets in a rising rate environment (read: Rate Hike Bet Put These Inverse Sector ETFs in Focus).
Play Niche Bond ETFs
Floating rate notes are investment grade bonds that do not pay a fixed rate to investors but have variable coupon rates that are often tied to an underlying index (such as LIBOR) plus a variable spread depending on the credit risk of the issuers. iShares Floating Rate Bond FLOT is a good bet in this context (read: FLOT vs. FLRN: The Best Floating Rate ETF).
Another option in this space is to tap bank loan ETFs like Highland/iBoxx Senior Loan ETF SNLN. Senior loans, also known as leveraged loans, are private debt instruments issued by a bank and syndicated by a group of banks or institutional investors. It yields about 4.45% annually.
By investing in investment grade bonds portfolio Proshares Investment Grade-Interest Rate Hedged IGHG, investors can alleviate rising rate worries through an interest rate hedge approach using U.S. Treasury futures. Since the fund targets a duration of zero, this could be an intriguing play right now. The fund yields about 3.34% annually.
Last but not the least, who can forget inverse bond ETFs in such a scenario? The product Barclays Inverse US Treasury Aggregate ETN looks to track the sum of returns of periodically rebalanced short positions in equal face values of each of the Treasury Futures contracts (see all Inverse Bond ETFs here).
Ex-Rate Sensitive ETFs Deserves a Look
Since both fears of a bubble in the market and the likely steepening of the yield curve may cause considerable volatility, a low volatile and an ex-rate sensitive pick like &P 500 ex-Rate Sensitive Low Volatility Portfolio XRLV should be an intriguing choice.
High Dividend ETFs to Rescue
Investors can seek refuge in even higher yield securities. So, PowerShares S&P 500 High Dividend Portfolio SPHD yielding about 3.80% annually can be a nice bet in a rising rate environment.
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