As the debate rages surrounding the timing of the first Federal Reserve (Fed) rate hike, we continue to discuss the potential tradeoffs surrounding this inevitable shift in policy. While some investors may be content to ride out the waning bull market in bonds, others may seek to position more tactically. We continue to believe that asymmetric risks remain in the bond market. As a result, investors should consider hedging interest rate risk.
Historically, investors have quantified the amount of interest rate risk in their portfolios via duration. For every 1% move higher in interest rates, a five-year duration bond’s price is expected to fall by approximately 5%. For those interested in expressing a view on rising U.S. rates, a negative duration bond strategy could provide investors a way to profit from rising rates (and lower bond prices).
As in most markets, there is no free lunch. One of the hurdles associated with a “shortâ€Â bond position is the costs of maintaining that position. What we mean by costs is that if a long position in a bond pays the holder interest, then a short position in that same security will require the short to pay the interest. A long bond position is akin to lending; a short position is akin to borrowing. For investors that believe higher interest rates are coming, timing is a crucial factor: time is literally money due to the cost of being short. Unless interest rates rise (and bond prices fall), the short position will experience negative total returns due to the impact of negative carry.
One option to help defray the costs of the short position is to invest in a portfolio of bonds (positive carry) and then “overhedge†the portfolio by selling longer maturity securities to achieve a negative duration target. Through our collaboration with Barclays PLC (NYSE:BCS) (LON:BARC) and Bank of America Merrill Lynch, WisdomTree has established strategies that are constructed on this simple premise.
