There's a Right Way and Wrong Way to Play Rising Rates in 2021

After the Fed cut to zero earlier this year, the investors generally thought rates would stay low for a long time. But as we approach 2021, the consensus is for interest rates to rise in the new year -- and that makes sense. The economy has performed better than most assumed it would at the start of the pandemic and now there's a vaccine on its way. I basically agree with the consensus view: Rates are more likely to rise than to fall. But fear is starting to set in, which is misplaced. There is a right way and a wrong way to play rising rates into 2021. Here are some of the risks and opportunities I see. Yields Can Only Go so High in the Short Term Long-term bond yields can definitely rise without the Federal Reserve actually hiking rates. But for yields to rise meaningfully, traders will have to be anticipating rate hikes in the future. A slightly simplistic, but fairly accurate way to think about long-term interest rates is that they are just an average of what the market expects short-term rates will be over the life of that bond. In other words, the 10-year Treasury yield should be approximately what traders think the average Fed funds rate will be over the next 10 years. So while it is true that during the 2008-2015 zero-interest-rate policy period, the 10-year often traded to 3% or higher, this was in anticipation of rates eventually normalizing. For example, when the 10-year hit 3% at the end of 2014, the Fed's own dot plot indicated that the long-run normal Fed target was 4%. In this context, the 10-year trading to 3% was pretty logical. The market was saying that short-term rates would be at zero for a year or two more, but then rise to 4% and average at that level from then on out. It isn't too hard to see how such a path would average out to about 3%. Now that same long-run normal target estimate is only 2.5%. That alone suggests that the top-end for rates is 150 basis points lower than it was in 2014. For example, yesterday's 3% is more like 1.5% today. That's an overly simplistic way to look at it, but I've run more detailed analysis. It is very hard to get the 10-year to rise any higher than 1.5% in 2021, without assuming longer-term inflation expectations actually rise above 2.5% or so. Nothing to Fear Here What kind of bond returns should we expect if the 10-year rises to 1.5%? It depends on what you invest in, as well as what happens to other bond yields. But history can be a pretty good guide here. I used two proxies for common bond portfolios: The ICE Broad Bond index (which covered the universe of investment-grade taxable bonds) and the ICE 1-10 Municipal Bond index. I then measured the price only return for each portfolio every time the 10-year rose by 50 bps since 1996. Using just the price return is important. With yields so much lower today, there's less cushion from income generation than in other periods. Measuring just the price return of these bond indexes makes it more of an apples-for-apples comparison. This analysis produced exactly 50 unique periods where the 10-year rose 50 bps. On average the taxable bond index was down 2.1% and the municipal index down 1.4%. The yields on these indexes right now are 1.1% and 0.6% respectively, so if we assumed that in one year the 10-year was at 1.5% and both indexes had that historic average performance, the total return would be approximately -1% and -0.8%. If you want to sell your bonds because a 1% yield just doesn't do it for you, I get it. Don't sell because you are fearful of catastrophic losses. The conclusion here is that a rate rise of about 50 bps in 2021 is probably the worst case scenario. If that happens, a general bond portfolio probably produces total return around -1%. So something like -1% is probably your worst-case scenario. When clients ask me about protecting against higher rates, I try to put it in that context. If you want to sell your bonds because a 1% yield just doesn't do it for you, I get it. Don't sell because you are fearful of catastrophic losses. Playing on the Fear In an investment world where frothy valuations abound, there could be an opportunity in unloved bonds. I took a look at closed-end fund premiums, and it is clear that any reach for yield trade hasn't made it to this market; 60% of municipal closed-end funds and 82% of high-yield closed-end funds are currently trading at a deeper discount to net asset value (or smaller premium) than at the start of 2020. I'm not a huge fan of junk bonds here, but that's strictly because of valuation. I don't think there's a lot of risk of substantially wider spreads in 2021. Buying high-yield bonds at a discount through closed-end funds is probably a good trade. I'd pick a basket of 10 or so that aren't especially concentrated in any one industry. The timing isn't quite as good for municipal closed-end funds. The best time to jump into these is when fear is at a maximum. The average premium/discount on these funds tend to follow retail investors assessment of interest rates, which to be honest, is a lagging indicator. If you wait until rates actually start rising in earnest, probably during the first quarter of next year, I'd expect the discounts to widen in the muni space. I will be waiting until then to add to this allocation. Bond Shorts Getting Popular I've written a couple times about how eager hedge funds have been to short Treasuries. That trade keeps getting frustrated and is probably a major reason why the 10-year yield have been stuck around 0.90%. It is clear, however, that shorting bonds is getting more popular among smaller investors, too. The share count on TBT , the double-short long-term Treasury exchange-traded fund, has increased by 11% since Sept. 30, and is now at its highest point of the year (outside of a one-day spike in March). Shorting bonds is a tough trade in general. I only recommend doing so if you have a very short horizon and understand that the return potential isn't great. Given that there is very limited scope for rates to rise in a big way, I think an outright short is a bad trade. If you trade technicals and want to do a two-to-three day short, by all means. But if you are trading fundamentals and thus have a horizon that is a month or more, the risk-reward ration just isn't in your favor.

There's a Right Way and Wrong Way to Play Rising Rates in 2021

The bet is now on rates hiking in the new year. Here's how to position best if that happens.

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