Tightrope Act

By Eric Uhlfelder

August 01, 2004 at 04:00 AM

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Investing in an environment of rising interest rates is a high-wire act. While bonds are paying more, their prices will continue to get smacked down until the cycle peaks. When that will be is the great unknown, making fixed-income investing a game that is part guesswork and part dollar-cost averaging.

The last two times the Federal Reserve went into tightening modes, in 1994 and 1999, the Lehman Brothers U.S. Aggregate Bond Index took it on the chin. Excluding coupon returns, the index ended the years down 9.5% in 1994 and 7% in 1999. The prospect of this happening yet again is sending some investors fleeing. In May, according to Lipper, investors yanked a net $17.5 billion from bond funds–the largest ever recorded by the fund tracking service.

Although nerves are on edge in the bond market, rising rates aren't likely to treat equity investors much better. The S&P 500 rose a paltry 1.3% in 1994. To be sure, bubble-happy equity investors kept the party going in 1999 despite continuous rate increases, with the S&P ending the year up 20.9%. But what followed for the next three years was as ugly as it gets. "Between the Fed first pronouncing fear of deflation, then turning 180 degrees and sounding inflation alarms," explains Mark Forster, portfolio manager at Kirr Marbach, an Indiana-based asset manager, "it's easy for advisors and investors to get paralyzed by mixed signals, especially as prices and interest rates rise, oil prices blow past record levels, and geopolitical uncertainty mounts."

However, the sheer fact that rates are going up doesn't inherently mean trouble for investors. The Fed is responding to inflation amid signs of renewed economic growth. This means that more people are working, pricing power is returning to corporations, and profits are rising. Even if the Fed pushes up rates by 200 basis points by the end of 2005–which is the general consensus–they will still remain at growth-sustaining levels. A recent survey of 34 economists by Business Week concluded that higher rates may not be a big issue because "low-cost financing and strong sales growth have left companies so flush they don't need to borrow much."

So why all the nervousness over rates? It's simple: Over the short term, at least, making money as rates begin to rise can be very difficult. According to Sam Stovall, S&P's chief investment strategist, stocks don't do very well for six to 12 months after a series of rate hikes is initiated. Citing six periods of rising rates since 1970, Stovall found that the broad market fell an average 5% in the six months after initial monetary tightening began. After a year, the index was off an additional percentage point. A few sectors did hold up: In the 12 months following the start of a cycle of rising rates, for example, information technology rose an average of 7%. Health care wasn't far behind, climbing 5%. But Stovall found that 55 of the 56 industries tracked by S&P fell during the first six months, suggesting that no one will escape the reckoning unscathed this time around.

Despite the likelihood of rough sailing in coming months, advisors shouldn't be making radical asset reallocations. "A well-balanced portfolio," says Steven Saker, VP of International Asset Advisory in Orlando, Florida, "should be designed to roll with changing interest rates as they cycle through periods of economic contraction and expansion." He notes, however, that at the same time, "advisors should always be mindful of making course adjustments as new risks and opportunities present themselves." Following are several course-correcting strategies that may help advisors sidestep some of the hazards of a rate rise, and in a few instances, even exploit it. As is common with most recommendations, phasing into positions through dollar-cost averaging should further mitigate risk.

Scaling the Ladder

While producing modest yields, shorter-term paper will have minimum volatility due to pending repayment. A consistent flow of maturities lets you reinvest in higher-yielding debt. While potentially more price sensitive, exposure to longer-term debt as rates climb will help pump up a portfolio's average yield.

With yields already shifting dramatically, deciding when to keep one's powder dry and when to invest will significantly affect total returns. This is no easy trick. Based on past rate cycles, Raymond Dalio, president of Bridgewater Associates, a Westport, Connecticut, investment management firm, expects Federal fund rates to peak at 4.25% and 10-year yields to top out at around 5.75%. He thinks these levels will be sufficient to slow down economic expansion without threatening growth. So he will phase his investments as rates approach these targets.

Are TIPS Too Pricey?

Treasury Inflation-Indexed Securities, popularly known as TIPS, appear to take a lot of the guesswork out of timing the market. Presuming that inflation is on the rise, TIPS will capture the change in CPI within its principal, helping the bonds to sustain their value despite rising rates. Though the coupon remains constant, increasing bond value helps generate higher yields.

Since their inception in 1997, TIPS have performed well in both bear and bull markets. The Lehman Brothers TIPS Index outperformed every other major bond and stock index during the equity bear market of 2000-2002, enjoying total annualized returns of 12.49%. Even after stocks and bonds rallied last year, the index sustained its three-year annualized lead through 2003.

Bill Davison, managing director at the Hartford Investment Management Company, which has $830 million invested in TIPS, found that for the year through June 22, total returns on four-year fixed-rate Treasuries declined 83 basis points due to rising rates. Comparably maturing TIPS were up 1.9%, or 190 basis points, because of the inflation accrual and greater price stability. Believing inflation and 10-year Treasury yields are likely to rise an additional 100 basis points over the next 12 months, to 3.75% and 5.75%, respectively, Davison thinks TIPS will continue to provide some protection.

However, some other managers think that TIPS have become too expensive. Because they offer inflation protection, TIPS coupons are normally less than those on conventional Treasuries. The difference is referred to as a breakeven inflation rate, or BEIR. According to Barclays Capital, the BEIR on 10-year issues continues to expand, from 2.50% in April to 2.67% in June. This means that inflation has to average above this rate over the lifetime of the bond for the TIPS investor to come out ahead of the investor in conventional Treasuries, which feature no inflation adjustment. But Varun Mehta of the Milwaukee-based Mason Street Advisors Select Bond Fund is currently phasing out his position in TIPS after a very good run. He doesn't believe their returns will continue to outperform those of conventional Treasuries.

Inverse Strategies

If you think yields of the 30-year Treasuries are going up, Rydex's Juno Fund and ProFunds' Rising Rates Fund offer you a way to profit. They do this by selling Treasuries short.

Investor interest in 10-year old Juno (RYJUX) has recently exploded, with assets rising from less than $100 million in 2002 to more than $3 billion in June. "Although created for market timers and speculators," explains fund manager Anne Ruff, "financial advisors increasingly rely on the fund to protect unrealized bond profits that have accumulated over the past several years."

For the year through May, S&P estimates that the fund climbed 1.29%, bettering the Merrill Lynch Corporate & Government Master Index by 1.87 percentage points. However, over the past three and five years, a period when rates were largely declining, the fund has significantly underperformed the broad bond index.

Juno has some major costs to overcome just to break even. When shorting a Treasury, explains Ruff, the fund must pay the owner of a bond the current yield, which on the 30-year issue was 5.38% as of late June. This was partially offset by keeping assets in an overnight repurchase account, which was paying 1.85% at the time. The net expense of carrying the trade was, therefore, 3.53%. Add to that the fund's annual expenses of 1.41%, and that means the fund must earn virtually 5% before investors are in the money. Ruff estimates that a rise of 0.35 percent in the 30-year Treasury's yield is necessary to cover investor expenses.

ProFunds Rising Rates Opportunity Fund (RRPIX), meanwhile, is a leveraged, more risky version of the Rydex fund, providing 125% inverse exposure to 30-year Treasuries. This means that the fund should appreciate 1.25 times the amount that Treasuries decrease. Barely two years old, with $679 million in assets, the fund through May was up 1.56% for 2004, outperforming the Merrill bond benchmark by 2.14 percentage points. Given the costs inherent in shorting Treasuries, the fund's 1.57% expense ratio further raises the hurdle. But if one suspects that interest rates are going to return to their historical mean, both funds will provide a unique means of profiting from rising rates. However, once rates start coming down, you won't want to be in either of these funds.

Opportunities in Big Caps

An alternative to shying away from the equity market is to gain exposure to a few stocks that have the strength to meet the turbulence of higher rates head on. There aren't many that fit this bill. But consistent with S&P's findings that technology and health care have been the top-performing industries when rates rise, companies like eBay and Stryker are likely candidates.

Despite the protracted tech collapse, eBay's shares are up at an annualized clip of 18.29% since June 1999. Even with the stock climbing a third through mid-June, eBay's business model remains the paradigm of the New Economy. J.P. Morgan's New York-based tech analyst Imran Khan projects 61% earnings-per-share growth for eBay this year, followed by 33% for 2005. "Better than expected revenue growth and improving margins should lead to multiple expansion," he concludes.

A play on the developed world's aging demographics, shares of global medical products maker Stryker have soared at an annualized rate of nearly 29% over the past five years. San Francisco-based Wells Fargo Securities health care analyst Wade King observes that, excluding the period around a 1998 acquisition, "Stryker has reported solid 20% earnings growth for more than 20 years." Merrill Lynch's Katherine Martinelli projects this growth rate to continue in 2004 and 2005. With the company being essentially debt-free and sporting a trailing price/earnings ratio of 45, Martinelli speculates that a significant acquisition could further drive earnings.

The Preferred Solution

New York Stock Exchange-traded preferred shares are debt-like securities that many advisors know little about. However, they often consistently yield 100 basis points or more over comparably rated bonds because they are less liquid and have a weaker claim on corporate assets. Many also lack specific maturities.

For example, Kevin Conery, preferred stock strategist at Merrill Lynch, compares an AA-rated Citigroup 10-year bond with a current yield of 5.80% and a Citi series Z preferred share sporting a current yield of 6.97%. Callable in September 2006 and trading slightly under its call price of $25, the preferred's yield-to-call would be 7.08%. Another lender issuing preferreds is Royal Bank of Scotland. In late June, two callable issues of the bank's dollar-denominated preferreds, series G and H, were both selling below their call prices and offering current yields of 7.4% and 7.26%, respectively. Even more enticing about these shares is that their dividends get taxed at the new 15% federal rate. However, Wall Street has developed a breed of trust preferreds–including the Citigroup issues–that are backed by bonds and therefore pay interest that is taxed at ordinary rates.

Despite their higher yields, preferreds are not a panacea. Like bonds, their prices move inversely to interest rates. The preferred market experienced a major correction in April, when fear of rising rates generated a total negative return of 4.64% for Merrill's Master Preferred Index, the single-worst monthly performance since January 1990. May witnessed further erosion in prices, until investors began seeing bargains and demand stabilized.

Banking on Foreign Lenders

Bank shares usually get hit when interest rates increase because the spread between their existing long-term loan rates and the cost of new money is shrinking. However, in a number of major markets interest rates have already cycled up well ahead of the U.S., suggesting that lenders in these countries may have moved past their most vulnerable stage. Looking at trailing five-year market performance through April, bank shares in these countries have sustained their value, in local currency terms, in the face of rising rates while paying dividends of 4% to 5%.

Australia is among the countries with promising high-yield bank plays. The country's overnight rates are up 100 basis points since mid-2002, to 5.25%. But over the 12 months through mid-April, Australia's six largest banks saw their stocks increase an average of 25% in local currency terms. Going back to April 2001, annualized price returns averaged 15.69%. Three of the banks–Westpac, ANZ, and NAB–have American depositary receipts that trade in U.S. dollars on the NYSE. Commonwealth Bank of Australia, Macquarie Bank, and St. George Bank trade only locally.

British interest rates, meanwhile, have been among the most stable around, moving within a 50-basis-point band since the end of 2001. However, starting in the fall of 2003, overnight rates have shifted up from 3.5% to 4.5%, with many observers expecting additional monetary tightening. Still, the five major British banks–HSBC, HBOS, RBS, Barclays, and Lloyds TSB–together rose 9.89% (in pounds) over the 12 months through April. Over the past three years, their share prices have increased at an annualized pace of 13.28%. And that does not include their average dividend yield of 4.5% and realized annual local-currency gains of 13.28%. Of the group, HSBC, Barclays, and Lloyds have ADRs.

UBS London-based banking analyst Christopher Ellerton believes that banks' increasingly risk-averse lending policies, deleveraging of the corporate sector, and the relatively healthy position of emerging markets suggest that the industry doesn't appear to be especially vulnerable to a credit shock. He sees profitability and capital position strengthening in 2004 and 2005.

High Yields Abroad

In April 2004′s cover story, "Foreign Appeal," we highlighted the merits of looking overseas for higher-yielding fixed-income plays. The reasoning still holds. Rates in a number of developed markets are significantly higher than ours. And because their central banks have already been tightening monetary policy for a while, interest rates are much closer to peaking in Australia, New Zealand, and Britain than they are in America. That means more yield and less capital risk.

John Kaupisch, foreign bond specialist at St. Louis-based Evergreen Direct Brokerage, is keen on short- and medium-term British and New Zealand government debt. As of mid-June, U.S. one-year Treasuries were yielding 2.14% and three-year bonds 3.4%. British gilts were paying 4.61% and 5.16% for one- and three-year maturities, respectively, while New Zealand's kiwi-denominated government debt paid out even more, yielding 5.93% for one-year and 5.98% for three-year credits.

Advisors should also look into inflation-protected sovereigns (see table on page 62). While the international market is less liquid than the American one, real yields in more than half the nine countries that offer inflation-protected securities exceed those paid by TIPS. Barclays Capital noted that in June, Australian securities were not only yielding 132 basis points more than U.S. 10-year TIPS, but the country had higher expected inflation–2.5% versus 2.1%–which, if realized, would further enhance Australian inflation-protected debt yields.

The main risk of investing in foreign bonds is currency exposure. As of June, the dollar had paused in its two-year slide. But many foreign exchange analysts believe that this is a short-term phenomenon. They expect that America's record current account, trade, and budget deficits will force the dollar down further. If this occurs, the dollar value of international assets will rise, further sweetening returns and highlighting the potential of foreign exchange as an asset class.

Will the Buck Bottom?

One near-term dollar bear is Lehman Brothers currency analyst Jim McCormick. He thinks that the greenback might very well sink even in the face of Fed tightening. "Over the past full Fed rate cycle, the dollar has tended to do the opposite of what you would think," observes McCormick. The dollar declined considerably during the 1994 tightening cycle, then stabilized and began a sharp ascent only after rates had steadied. Despite repeated rate cuts that brought the Fed funds rate to 46-year lows, the dollar only began its present slide after the Fed was virtually done cutting rates. McCormick believes "U.S. yields need to stabilize at much higher levels then they are today if Fed policy is going to play a role in turning the dollar around, especially with a current account deficit heading toward 6% of GDP."

You can gain foreign currency exposure in various ways. The easiest is buying country-specific exchange-traded funds or dollar-denominated ADRs. It's also possible to prospect directly on foreign bourses. With a number of global large-cap companies paying dividends from 4% to 5% and foreign sovereign debt offering comparably attractive yields, sitting in such securities provides cash flow and an opportunity to look smart should the dollar weaken further.

More sophisticated players may also want to look into currency options and futures. One way to play these investments is through managed futures programs run by commodity trading advisors. These hedge-like funds are designed largely for qualified investors with large minimum investments. Some CTAs have partnered with major brokerages, like Merrill Lynch and Morgan Stanley. Take Campbell & Company's Financial Metal and Energy Portfolio, which is largely a financial play with half of its $7 billion assets in currencies and much of the remainder in interest-rate instruments and financial indexes. The portfolio is available through dozens of brokerages, with minimums of $100,000 and less. Its annualized five-year return, net of expenses, through May 2004 was 11.1%, versus -1.53% for the S&P 500. Its standard deviation was 14.29, compared with 16.7 for the broad equity market. But remember that CTAs' effectiveness is limited when markets are trendless, as they were in the first half of 2004.

Remember, too, that rates may defy the pundits and fail to head substantially higher if it turns out that the economy is growing less vigorously than anticipated. Wall Street, however, is betting that the recovery isn't faltering and rates have room to rise. In that case, you'll need to find ways to add a bit of alpha during a time in which most portfolios will be struggling.

Eric Uhlfelder covers international investing for publications including The Financial Times, The Wall Street Journal Europe, and Institutional Investor. He can be reached at [email protected]. His book, Investing in the New Europe (Bloomberg) is available through the IA Bookstore at www.investmentadvisor.com.

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