Sunday, January 23, 2011

Betting on Interest rate movements

Interest rates are now at historical lows across the board (here) , driven largely by the Federal Reserve's quantitative easing initiative. Yields on all forms of debt have been pushed down as the Fed continues to add Treasuries and other Securities to its balance sheet. At some point this will reverse and yields will start to rise, though it is anyone's guess when this will happen.

Given the Fed's intent to keep printing money until the economy "recovers", this quantitative easing could go for some time. We might end up in a replay of the situation in Japan, where a sluggish economy and low interest rates (here, and here) have persisted over many years. Though I think it is unlikely the US will face such an extended downturn - Japan's difference is that it has a rapidly aging (and soon to be shrinking) population, and structural rigidities in its economy that make it difficult to reconfigure itself to work within its new demographic reality.

When yields starting heading upwards, the shift is likely to be swift and sustained. There are a few ways to bet on this trend when it happens:
  1. One way to profit from this movement when it happens, is to short bonds.

  2. Another way is to buy put options on ETFs that track bond prices. As the move is likely to take months to years to play out, buying LEAPs on the ETFs tracking longer dated bonds will give you a larger window in which to catch and ride the yield upswing.

    This approach is relatively accessible to retail investors; just remember to read the LEAP product specifications (for example, 1 LEAP contract may represent an interest in 100 shares of the underlying "stock") Here are a couple of ETFs that track Treasury Bond prices:

    - iShares Barclays 1-3 Year Treasury Bond (SHY)
    - iShares Barclays 3-7 Year Treasury Bond (IEI)
    - iShares Barclays 7-10 Year Treasury (IEF)
    - iShares Barclays 20+ Year Treas Bond (TLT)

  3. You can also buy put options on interest rates on the CBOE (CBOE) IRX, FVX, TNX, TYX