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Lifting Barbells As Rates Rise

by Stephen Taub

It?s no secret that the Federal Reserve will soon raise interest rates. But, we still don?t know when, how much and how many times.

This uncertainty will clearly impact not only your returns but also the strategy you deploy over the next few years.

?The big question is, how do we get there?? explains Antonis Mistras, senior portfolio manager at Dupont Capital Management, which runs $5 billion in fixed income.

So, he offers a sort of hedging strategy that enables investors to enjoy a decent return and benefit from rising rates.

?Right now you want your portfolio to have a short duration,? he explains.

Mistras, who is responsible for all U.S. and international government portfolios, points out that the spread between short-term and long-term rates is currently extremely wide by historical standards.

For example, the difference between the two-year and 10-year Treasury is 218 basis points. Over the past 20 years, the mean was closer to 95 points while the low was minus-40 points?in other words, the market moved to an inverted yield curve, which wound up signaling a recession.

The high did reach as wide as 259 basis points, but the last time the gulf was as large as it is today was back in late 1992.

Currently, the spread between the two-year and 30-year is 300 points and the difference between the five-year and 30-year is 126 points.

?During an economic recovery, that spread turns and moves closer to flat,? Mistras explains. And it can tighten rather quickly.

For example, back in the early 1990s, the spread between the five-year and 30-year went from 196 points to zero in just two years, he points out.

The lesson for investors: Even though long rates seem much more attractive, you should not put all of your dough in that basket.

?If you don?t want to increase your exposure to rates, you must invest smaller amounts in the long end,? he counsels.

So, what should investors do now?

He says if you think the yield curve will flatten over the next few years, it will be because short-term rates will go up much more than long rates will rise.

Mistras recommends creating a barbell portfolio with cash and the 30-year bond. He figures one-third of your bond assets should go to the long end and the rest to cash.

The problem with that position is if rates stay put longer than many expect, then you would have bet wrong and would have earned more putting most of your money in the five-year note than splitting it one-third in the 30-year and two-thirds in cash.

?The benefit is you are setting yourself up for a much better defense versus capital losses,? he adds. ?The five-year will be creamed if the Fed raises interest rates.?

Also, the yield curve is so steep it is bound to correct, Mistras believes.

So, if you adopt his recommended barbell strategy, remember that you?re also making a bet that the Fed is going to move on rates. Adds Mistras: ?It?s a better way to play the economic recovery and the Fed increasing rates than just selling bonds and going to cash.?

And what about corporate bonds?

He advises to stay away from the highest quality paper?AAA and AA--because the spreads, to Treasurys, have tightened tremendously. ?There doesn?t seem to be much upside relative to Treasurys,? he adds.

He believes the yields on high quality corporates and agencies will go up more than Treasurys, resulting in losses to current holdings. Why? ?The additional yield is more related to liquidity considerations than credit considerations,? he explains.

Rather, if you want to invest in corporates, Mistras recommends the lower end of the credit spectrum?junk bonds.

But, keep in mind that the speculative grade bonds are already coming off a huge rally, with gains having attained forty-plus percent, that started in the fall of 2002. In fact, some of the savviest hedge fund managers who made enormous gains in that market have already moved onto the next opportunity.

Meanwhile, individual investors have yanked money out of US junk bond mutual funds for five weeks in a row, further reducing liquidity.

Mistras acknowledges these developments, but insists, ?there?s still some upside left.?
 

Stephen Taub is Contributing Editor to BondsOnline. Stephen has been covering financial markets for more than 20 years with Financial World magazine, Individual Investor.com, CFO.com, and others.