How to Triple Your Returns on Rising Interest Rates
Tuesday, May 26, 2009 | Teeka Tiwari
Many of you will be tempted to buy on this pullback, but don’t do it -- at least, not yet.
If you buy on this weakness, it's only going to serve as a liquidity event for the smart money. Stocks will be a buy again, and I don’t think we’re going to have to go all the way back down. But now is not the time to be getting long.
You also want to be very wary of the bond market right now. There are some very scary things taking place there.
Bonds: The Next Bear Market?
Back on March 19, the Fed announced that it would pump $1.25 trillion into government bonds. On the day of the announcement, bond prices soared as the rate on the 10-year bond declined by 54 basis points to 2.59%.
As of last Friday’s data, the yield on the 10-year bond now stands at 3.45%. So, we can see that the March rally was purely short-covering by nervous traders. The Fed is buying up all this government paper in an attempt to keep interest rates low. Its plan is to spur economic activity via artificially low interest rates.
The problem is it's not working; even with all that firepower at their disposal, they cannot keep rates from rising. As such, the next major financial bear market could well be in U.S. government bonds.
Do not buy bonds; you will almost certainly lose money. More than $3 trillion will be borrowed by the U.S. government this year, far more than in any other year. In order to attract global investors, rates will have to go up.
Five-percent coupons on the long bond look to be in the cards but, as we saw in the 1980s, interest rates can go to 18% or more. At this time, there is no plausible way to tell how high rates will go, but we can very reasonably assume that the overarching trend will be higher rates, not lower ones.
Interest Rate Increases Can Be Great News for Your Portfolio
Aside from trading interest-rate futures, there are several Exchange-Traded Funds (ETFs) that allow you to profit from government debt interest-rate fluctuations.
One particular ETF for the long bond is the Lehman Brothers 20 Year Treasury Index (Symbol: TLT). If you think rates are going up, you can short the TLT . If interest rates rise, the price of TLT will go down. The opposite is also true; if interest rates drop, the TLT will rise in price.
Just remember, if you short TLT, you are on the hook for the interest-rate payments the same way that you have to cover the dividend payments when you short a stock.
A way to mitigate that risk is to trade put options instead of short-selling. A put option will go up in price as TLT goes down in price. It has the added benefit of having no requirement to cover the interest payments that you would have to pay if you shorted TLT directly. Another advantage with using put options is that you can’t lose more than you "put" into the position -- the amount you spend to buy the puts is your maximum dollar amount at risk.
Double, Triple Your Profit Potential on a Single Trade
If you don’t want to short TLT and you don't want to buy options, there is another way that you can play rising rates. ProFunds has two leveraged ETF products, one that tracks the TLT and another that tracks the 7-10 Year Treasury index. They are the ProShares UltraShort Lehman 7-10 Year Treasury ETF (Symbol: PST) and the ProShares UltraShort Lehman 20 Year Treasury ETF (Symbol: TBT).
These two "UltraShort" ETFs are what are known as "inverse" ETFs, which means that they go up in value as the index they track goes down in price. There is one big difference, though -- that term "Ultra" means that you get leverage of 2-to-1. So, for every 1% the index goes down, the Ultra ETF will go up by 2%.
Remember that leverage works both ways. If the index goes up 1%, the Ultra ETF will go down 2%. If you wanted to leverage your position further, you could use options. Both of these ETFs have both puts and calls available to trade. Because the Ultra ETFs go up when the index goes down, you could substitute call options instead of directly buying the ETFs.
Inverse ETFs are terrific for investors who are unable or unwilling to trade on margin. All short sales require a margin account. This means that inverse ETFs can be bought in a non-margin account such as an IRA.
If you really want to put on your cowboy hat and go "buck wild," there is a product for you. Direxion -- a name you might have heard as a way to play the bank-industry woes, via the Direxion Daily Financial Bear 3x Shares (Symbol: FAZ) -- has set up four separate triple-leverage interest-rate ETFs.
• Direxion Daily 10-Year Treasury Bull 3x (Symbol: TYD)
• Direxion Daily 30-Year Treasury Bull 3x (Symbol: TMF)
• Direxion Daily 10-Year Treasury Bear 3x (Symbol: TYO)
• Direxion Daily 30-Year Treasury Bear 3x (Symbol: TMV)
Each of these ETFs will give you triple the return of the daily move of the underlying index that they track. They provide a bullish and bearish ETF for both the 10-year Treasury note and the 30-year Treasury note. Each of these ETFs also trade options.
A word of warning on the Direxion products: They are really geared toward daytraders and are not appropriate for long-term holds. The reason is that, over time, the relationship of the ETF pricing and the underlying index degrades. If you are going to play the triple-leverage ETFs, make sure that you have a tight stop-loss in place and recognize that these instruments are designed for daytraders, not longer-term investors.
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Teeka Tiwari
Chief Investment Officer
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