AWAITING THE GREAT ROTATION

13 June 2013


Source: Bloomberg

So far in 2013, it hasn’t quite been the ‘Great Rotation’ (out of fixed income, and into equities) that we have been expecting. From where I sit, LATAM sovereigns and corporates remain largely overbought. But does that mean it’s far away? The S&P 500 has risen ~11% YTD, with little sign of weakening.

More recently, and perhaps more importantly, the expectations of an interest rate hike have become increasingly imminent. The Fed has spooked many investors and investment managers alike; although their rhetoric remains somewhat unclear:Bernanke; May 22, 2013:

“A premature tightening of monetary policy could lead interest rates to rise temporarily but would also carry a substantial risk of slowing or ending the economic recovery and causing inflation to fall further,” Bernanke said today in testimony to the Joint Economic Committee of Congress in Washington.

San Francisco Fed President John Williams; May 23, 2013:

“You could even imagine a scenario where we adjust it downward based on good data and then adjust it back, if the economy weakened”, he said. “We can adjust it down some, watch how things progress from there, and then adjust it again one way or the other.”

 

What can be said with some certainty is that we’ve experienced a prolonged bond bubble which can’t be sustained in perpetuity. With that in mind, here are a few ideas to hedge against rising rates.

 

 

1.   Floaters

This may be the simplest transition for the fixed-income minded investors out there. These reset at stated intervals, e.g. every 3 or 6 months. At the start of May 2013, there was talk of the U.S. Treasury issuing floating rate notes in the coming months to protect investors. “For now, the Treasury is considering monthly sales of $10 billion to $15 billion worth of floating-rate debt with a two-year maturity.” (Wall Street Journal)

2.   High- Grade US Bank Equities

Think Bank of America, Wells Fargo and Citigroup. Eventually, higher rates will increase the spread that the banks earn from lending compared to what they pay on deposits.

Bank of America (BAC) currently sits on $1.1 trillion of deposits against $900 billion in loans. Those deposits are an unbelievable “asset” to have going forward. According to BofA, a 1% increase in interest rates would positively affect its bottom line by $4 billion to $5 billion dollars.

(Real Money)

3.   Exchange Traded Funds (ETFs)

Example: Proshares Ultrashort 20+Year Treasury. This fund in particular seeks results that correspond to twice the inverse of the daily performance of the Barclays Capital US Treasury 20+ Year Treasury Bond Index. Essentially, as Treasury prices fall and rates rise this ETF should perform better. Of course, one should always consider the liquidity implications and strategies implemented for any type of fund. This is currently just over $4 above its 200-day moving average (considered a useful indicator – Forbes), most likely due to increased demand but may still have value in the event of a rate hike.

4.   Fixed For Floating Swap

Another way to benefit from rising rates would be an interest rate swap in which the counterparty pays a fixed rate on some notional principal, in exchange for receiving floating rate payments. Swaps, given their high liquidity are often viewed as a more accurate rate benchmark than Treasury curves.

This may be a lot to take in, but it is certainly worth the time to protect against a potentially rough summer. For more details, please feel free to contact us as we all want to prepare for the interest rate ‘when’ given that the ‘if’ seems to be answering itself already.

Please contact us at info@nullfirstlinesecurities.com.

Gerard Stephens

Account Executive

Sales and Trading

 

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