Alternative strategies for investors to position their portfolios in a rising rates environment

Fixed-income markets might be experiencing the calm before the storm. Rather than allowing complacency to creep in, following the normalization of markets after the significant sell-off in the second quarter of 2013, thoughtful investors should at least be thinking of how best to protect themselves from the risk of rising rates.

There are various trades/positions available to fixed-income investors to deal with their current duration risks, encompassing different subasset classes within the fixed-income space as well as different financial instruments.

One way to look at the trades addressed in this article is according to two main attributes: simplicity and efficiency.

Simplicity expresses the level of financial expertise required to set up, manage and close the position.

Efficiency expresses how much it costs vs. the potential benefits it can provide. For instance, certain strategies have less upfront costs and can even potentially generate modest positive returns while providing duration protection. One example would be how much a position costs or how much it yields in order to keep the position open assuming markets are unchanged: it's what is commonly called the “carry” of a trade, which can be either negative (the position loses money in unchanged markets) or positive (the position makes money in unchanged markets).

As frequently happens in life, there is a negative trade-off between simplicity and efficiency, so investors have to make choices depending on their circumstances.

The “natural” response to duration risk is to either sell long-dated bonds or to establish a short position in duration itself, which can be accomplished either by directly shorting Treasuries or swaps at the back end of the curve (seven-year maturities and out), or via options, on either Treasuries and/or swaps.

Both approaches score relatively high in terms of simplicity of implementation but poorly in terms of efficiency, because they both display negative — sometimes significantly negative — carry. On the positive side, they offer immediate profits if rates indeed rise and/or the yield curve steepens, a benefit that is nevertheless countered by the fact that both strategies are highly dependent on the timing of entry and exit of the position.

The difference between these two approaches to express a short-duration position lies in the standard attributes of options: i.e., being penalized less if, contrary to expectations, rates decrease and/or the yield curve flattens; favorable convexity; positive exposure to increasing rate volatility and negative exposure to option time decay.

At the other end of the simplicity vs. efficiency trade-off we find positions characterized by more favorable carry characteristics — from negligibly negative carry to a modestly positive one. Such efficiency, however, can be achieved only at the price of high complexity and can only be executed effectively by sophisticated investors and traders with specialist expertise. As an additional plus, the proposed trades in this group are relatively independent of the timing of entry and exit of positions.One such trade is playing the steepening of the yield curve — a very likely consequence of rising rates — by using swaptions instead of an outright short position. This trade relies on the relationship between the spot and the forward rate curves and is characterized by favorable convexity. Investors in this trade should watch out for any curve-flattening caused by surprise hikes from the Fed and for the possibility of unlimited losses from being short options.

Other complex, yet efficient, trades employ specific instruments from the mortgage-backed securities market, either in isolation or in their relationship with the government bond market, to express both directional and non-directional views on interest rates. Part of the complexity common to trades involving MBS is that their success crucially depends on both the selection of the right securities and their subsequent active trading.

A possible trade is to go long Treasuries and short specific types of MBS securities, to play the widening of the mortgage basis, the spread between Treasury and specific mortgage-backed security (pass-throughs) total return profiles. On the plus side, due to the positive convexity of the overall position, this trade is expected to be profitable, at least in the short term, for sizable rate moves in either direction. Furthermore, it provides a long exposure to political risk through expected additional profits should any new U.S. government-sponsored streamlined refinancing program be enacted. The trade is, however, at risk from the continuation of Fed tapering being focused solely on its Treasury purchases (unlikely) or a reduction in the pace of expected Fed tapering or an increase in Fed purchases if the economy weakens dramatically. Any of these Fed actions could in theory lead to short-term losses. However, at these price and spread levels expected losses would be extremely modest in comparison to potential upside.

An alternative trade, still involving the MBS market, is to express a directional view on rates using interest-only MBS and swaptions. Here, the “optionality” attribute of the swaptions determines the main drivers of profit and loss for this trade and the interest-only MBS securities provide positive carry. It should be noted this trade has a short exposure to the political risk concerning MBS refinancing, hence it is going to be hurt by any new streamlined refinancing program.

Last of these types of trades is a positive carry long position in interest-only MBS hedged with Treasuries. This does not explicitly express a directional view on rates. Instead, it provides an implicit view on rates since the already attractive positive carry streams should increase over time as interest rates rise. This is due to a decline in refinance activity that would come from higher interest rates and the further reduction of political risk in the form of any new U.S. government-sponsored streamlined refinancing programs. There are, however, three main drawbacks to this trade. First, the negative convexity of the core assets, which requires a high level of proficiency in hedging rate moves. Second, profits from the trade might take awhile to materialize because large rate moves higher tend to increase price volatility which, in turn, can result in short term mark-to-market losses in the position. Third, the trade is short U.S. housing market political risk as well.

There is a range of options to guard against rising rates. How investors approach this challenge depends on their individual requirements, particularly the balance they decide to strike between simplicity and efficiency, and, of course, their view on the most likely future direction of interest rates.

Troy Gayeski is a partner and senior portfolio manager at SkyBridge Capital, New York.