Why Investors Should Be Wary of Rising Rate ETFs

When a new class of investments hits the market I prefer to remain on the sidelines and watch from a distance.
In the past year, the market has been hit with new income funds that purportedly protect investors’ principal against the ravages of rising interest rates.  Called “Rising Rate” ETFs, these funds focus on short-term bonds, or employ derivatives and shorting strategies.
The Wall Street Journal reports that 17 of these rising rate ETFs have been launched or have filed plans to launch in the past six months. The funds already on the market have attracted $430 million from investors. That dollar amount is sure to rise.
I understand the attraction: Many investors want non-equity income alternatives. They want the security of income and principal that a quality bond provides. They also want principal protection should interest rates rise.
The following bond ETFs offer that protection, but for a price.
Investing in a portfolio of short-maturity bonds will limit principal loss if interest rates rise, but investors sacrifice income for safety. The Vanguard Short-Term Corporate Bond ETF (NASDAQ: VCSH) yields 1.8%, while the iShares Short Maturity Bond ETF (BATS: NEAR) yields less than 1%. The elusive free lunch has yet to be found.
ProShares Investment Grade-Interest Rate Hedged ETF (BATS: IGHG) is another principal protector. The fund employs a sophisticated strategy of buying corporate bonds while selling short U.S. Treasury securities of similar duration. This strategy dampens interest-rate fluctuations in return for a yield that fails to reach 1%.
Investors convinced interest rates are on the rise who want to maximize their return should consider ProShares Short 20+ Year Treasury ETF (NYSE: TBF). The fund correlates positively with the yield on the 20-year U.S. Treasury bond. If the yield on the 20-year bond rises, so does the value of the ETF. Again, income is the glaring shortcoming; there isn’t any.
Here’s something else income investors should consider: interest rates won’t rise.
The majority opinion says that rates will rise as the Federal Reserve tapers quantitative easing. Rates rose in the second halve of 2013, when the Fed hinted tapering was in the cards. Once the Fed began tapering in December, rates actually trended lower.

10-Year U.S. Treasury Note Yield


Investors are convinced interest rates have to rise because the Fed is creating less demand for government bonds. Less demand equals a higher yield and lower bond prices to attract buyers.
Monetary inflation is also expected to get interest rates moving. The Fed has continually flooded the financial system with money since the 2009 recession. But this new money has yet to suffuse the economy.  Much of it remains entombed at the Federal Reserve as excess bank reserves.
We can look to Japan to see why continual floods of money don’t necessarily lead to higher interest rates.
Last year, the Bank of Japan pledged to inject $1.4 trillion yen into Japan’s financial system, which it subsequently did.  Since then, the yield on Japan’s 10-year government note has actually dropped to 0.6% from 0.8%. Like in the United States, the new money remains in reserve.
In other words, investors in rising-rate ETFs are seeking insurance against a possible non-event.
Because I’m skeptical higher interest rates are on the horizon, I think investors should still consider higher-yield income investments. Decent yield on quality bonds is as rare as snow in July. Therefore, I  think it’s worthwhile to focus on quality equity investments: business development companies (BDCs), REITs, and preferred stocks.
Tomorrow I’ll offer my top recommendation in each category.

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