(publication date: 17 March 2017)

The Dutch text version of this article can be found on: www.iex.nl

Introduction

Before you is part three of a series of articles in which we discuss how you as an investor can deal with an environment where long-term rates rise structurally. In Part 2, we discussed two funds in order to clarify the differences in maturity strategy. We concluded that an ordinary bond tracker generates far too much risk for the investor, while the investor doesn’t know he or she holds a portfolio, whose duration is currently getting longer and thereby increasing its interest risk. Conversely we discussed a fund in which the duration is adjusted actively by the fund manager, Robeco Lux-O-Rente Fund. This fund can protect itself against rising interest rates by reducing the duration to zero. But the disadvantage of such a fund is that it takes time for it to align its strategy (the first phase of a rise in interest rates always costs money) and that it cannot go short in the bond market. In such a case, the fund may well avoid that it will lose even more money while rates are rising, but the fund it will still not be able to make money when interest rates rise. The question with which we ended Part 2 and begin this article is thus: are there funds that do make money when interest rates rise?

Buying funds that can short the bond market

In August 2015 we published an article in which we discussed this question. In this piece, we first consider the question of what it means to be “short” in bonds and what the risks are that belong to this type of investment strategy.

To be able to go “short” in a bond one has to borrow a bond from an existing owner, sell this bond and then at a later date repurchase the bond in the market (preferably at a then lower rate) and then return the bond to the person from whom the bond was borrowed earlier. This is the underlying process that lies at the basis of every product that allows you to go “short”.

In our article, we then tackled a number of problems, that will be faced when going “short” in bonds such as:
• The person who lends you the bond will charge you the interest on the bond that is built up during the time the bond is borrowed;
• You may be unsuccessful and the price of the bond may rise during the time you borrowed the bond;
• Borrowing bonds as such costs money;
• By the time you have to give back the bond it may no longer be available;
• The chance that you are right also has a price.

For a detailed explanation of these points we refer you to our earlier article on this subject (see the link attached to this sentence) and will therefore not go into this in this current article. But one should read the earlier piece as it is important to be aware of the risks associated with going short in bonds.

Bond funds that can short the bond market

There are both funds that track an index (ETFs) and funds that actively deal with the possibility to short the bond market (funds think they can offer Alpha by introducing their own active strategy). Trackers are usually cheaper (lower expense ratio) but they must abide by a pre-determined index or strategy and therefore cannot at their own discretion change the strategy. If you think rates will go down and you own a tracker that tracks an index, you cannot expect the administrator of this tracker to sell the underlying investments, you need to sell the fund yourself. In an actively invested fund, the fund manager may sometimes, based on his own analyzes, sell the underlying values and repurchase other assets. Your asset manager (such Vladeracken), can also execute such strategies.

Trackers that short a market or index

There are ETFs that follow the exact opposite strategy of the underlying index. If the underlying index rises, then the value of the fund drops. If the index falls, then the value of this fund increases. In fact, such a fund will constantly short the relevant index. The problem of “continuously shorting a market” is that this is only possible by making use of derivatives. These funds as such will always be “synthetic trackers” (see our article from 2015). And that automatically creates, in the case of short positions, the risk of contango. And we wrote: “This is the risk that arises because the term used should always be extended again (rolled). The problem signifies that funds that short an index will fall in value by definition, unless the underlying asset does what the short investor bargains for, which is a drop in the price of the underlying asset. So if the price of the underlying asset remains the same, the price of a short-tracker will still gradually sink. This is a direct result of all the costs associated with short selling of securities or other financial values.”

Using a tracker to benefit from rising interest rates therefore requires the investor that he himself has an active interest rate policy in order to actively buy and sell the tracker! Short trackers are not a “ buy-and-hold” -investment.

Trackers that short the bond market

In 2015, we discussed two trackers that short US government bonds (Treasuries). In these two trackers the investor is also exposed to a currency risk (US $). As we continue the sequel of this series, we will come back to these two trackers because the currency risk adds an additional risk. We will first focus on a tracker that shorts € bonds:

Lyxor ETF Daily double Short Bund (ISIN-code: FR0010869578)

This is a created by Lyxor, an ETF-specialist. The tracker is listed on the Paris Stock Exchange (Euronext). The fund takes on a daily double short position on the German Bund Index. That means that 1% depreciation of the Bund Index should provide an appreciation of the tracker of 2%. This is therefore a fund with a leverage of 2. This provides an additional risk because the leverage also works the other way. In addition, this is a synthetic tracker. The short position is built with derivatives in the Bund Index. They need to be replaced regularly (the position is adjusted on a daily basis) and that costs money. How much money can be seen in Figure 5.

Figure 5.

At the top of the graph we have drawn the price development of the German Bund Future. The bottom of the graph shows the price performance of the Lyxor Tracker. Between 2010 and 2016, the Bund future rose from a peak (in this chart the first) of 135 to a peak of 169 in June 2016. That’s an increase of over 25%. The tracker fell during that period from a price of € 80 to a low of € 36, a decrease of 55%. That is more than double the increase. The difference is in the cost of the tracker itself and the costs of having to maintain and role over the derivatives that keep the fund short in the Bund market.

Timing is important

The Bund Index is an index of German government bonds with an average maturity of 10 years. For a detailed description of the index and futures on this index we refer to an article that we publish at the end of August 2015 (part 6 of the series of 2015). Suffice it to say that this index behaves like the price of a 10-year German government bond with a coupon of 6%. If interest rates rise, then this index drops, if the interest rates fall, the index rises. In the graph, we have highlighted three periods when interest rates rose (A, B and C). In all three periods the price of the tracker (at the bottom of the chart), in fact rose. But the graph also shows how important timing is. The interest rate increases have occurred at a much quicker pace than the rate cuts and so to earn money you had to time both the entry point and the exit point particularly well. And that is extremely difficult, if not impossible, for most investors.

Head-and-shoulder and double bottom formations

But the chart also shows something else. In the top right part of the graph, we have highlighted a head-and-shoulder pattern. The Bund Index has almost finished a topping formation in the form of a left shoulder, a head and a right shoulder. The support line, where the index currently trades, is called the neckline. A break down is a statistically significant event. If that happens, a price target can be calculated for the Bund of 149! That is a decrease of 6.3%, which coincides with the support generated by the peaks of 2013 and the bottom in 2015. For the tracker, this means a potential price increase of over 12% from the current level of around € 39 (a target of € 43 to € 44). That is lower than the peak reached in 2015 when the Bund also fell to 149 points, because at that time the tracker recorded a high of € 48.50!

Conclusion as to short-trackers

In the short term this type of trackers can provide a solution, but they are by no means an instrument to hedge a long-term bond portfolio. Moreover, you yourself have to keep an eye on the right timing and that can sometimes be dependent on specific days. Most investors have too much distance to the daily business on securities markets and should not start involve themselves with these instruments.

Professional investors

For professional investors such as fund managers, things are different. They can act directly in the market for Bund Futures, they can keep busy all day with these markets and they can thus develop an active strategy to hedge the risk of bonds with derivatives or even actively try to use phases in which interest rates rise to generate profits. However they must have the opportunity to implement such a strategy. We have already seen that a fund such as Robeco Lux-O-Rente Fund may be able to carry an active strategy, but that on the basis of the prospectus this fund may not go short in bonds. They can never make money when interest rates rise, they can at best prevent them from losing money in such periods stages.

Investment funds that can actively short bond markets

A fund that can actively short bond markets (and which we have discussed earlier) is the Carmignac Global Bond Fund. At that time we concluded that the managers of this fund, although they were enabled to go short in bonds, had not exactly proven, that they were able to use this option in a lucrative way in the past. But a change seems to have taken place. Please refer to Figure 6, where you will find the price performance of the fund.

Carmignac Global Bond Fund (ISIN-code: LU0336083497)

Figure 6.

This is the share class of the fund, on which no dividends are paid, a real interest rate growth fund. In the top part of the graph, we have again drawn the Bund Future. To the right in the figure we have again shown the neckline of the top pattern which we have already described in Figure 5. At the bottom of the figure one can see the price performance of the Carmignac Global Bond Fund. In this figure we have marked two periods in which the interest rates have risen earlier. One period is the period between 2010 and 2011 and period B, a much shorter period, depicts the brief rise in interest rates in 2015. Both phases show a fall of the share price of the fund similar to that of the Bund future. So the managers have apparently made the assessment that the interest rate increase would be relatively short-lived and that therefore there should be no attempt to take advantage of the increase. Here is a disadvantage of a fund that follows its own active investment strategy. Their expectations could be wrong!

In both cases one can see that the price of the fund still keeps falling even after the interest rates reverse their direction. Apparently ultimately the fund managers do fit the strategy and it takes them time to adjust their strategy to the right direction of the market. This is a problem that we have also seen in the Robeco Lux-O-Rente Fund. Most active fund managers use models to determine the direction in which they should invest. But models are usually tracking systems and thus have the disadvantage that they are always slow to respond to new developments.

This is probably the reason why Carmignac has not been able to profit from the interest rate increases in 2010 and 2015. But 2016 shows a very different picture. While the Bund Future clearly makes a topping movement and is now declining, the price of the fund has kept on rising steadily. They now benefit from the rise in interest rates!

Premature conclusion

However our conclusion may be somewhat premature. Because this fund invests not only in € denominated bonds. The fund has the possibility to reduce the average maturity of the bond portfolio to minus 4 years. Thus it can short bonds. But in the same prospectus it is indicated that the fund may also invest in currencies other than the €.
In its most recent monthly report (late February 2017) Carmignac indicates that the average duration of the portfolio is 0.12. This is almost zero, not negative!

Conclusion

So on balance, currently the fund isn’t shorting the bond market. But the report also shows that the fund holds approximately 42% in $ denominated bonds, holds a short position of 5% in the British pound and is even 8% short in the yen. The current appreciation of the Fund is due to the fact that it does not lose money at a time when interest rates rise, and that meanwhile the fund makes money by running an appropriate currency strategy!

So its profit stem from the mix of currency investments, not from the rise in interest rates. So the fund is doing the correct thing, but you have to remember as an investor that you have an additional risk here!

Next week we will therefore consider the next strategy, which many bond funds have available, which is an active currency strategy.

The Hague, 17 March 2017
Gijsbrecht K. van Dommelen
Vladeracken Vermogensbeheer

www.vladeracken.nl

Disclaimer
The author is responsible for the investment policy at Vladeracken BV, an asset management company licensed by the AFM. Vladeracken invests and / or has invested in the securities discussed herein on behalf of its clients. This piece is not an investment advice. Whoever invests in the securities discussed herein and in accordance with the methodology and arguments discussed, or wants to invest accordingly does for his or her own accountability and risk. In this context, the author and Vladeracken BV disclaim all responsibility for the contents of this article. The securities and methods discussed represent a high risk.

(Publication Date: February 24, 2017)
De Nederlandstalige versie is op 6 maart 2017 verschenen op www.iex.nl.

Introduction

In 2015 we wrote a series of articles in which we wondered what the bond investor should do in an environment where interest rates do not structurally fall, but instead rise over a long period of time. Like many, we were on the early side, but now this question has become extremely relevant.

The risk of an interest rate rise

Figure 1 shows (top) the price development of a government bond which is issued by the Dutch government in 2007 with a term of 30 years at the time. The remaining term is now 20 years and the loan is still considered long term. At the bottom of the figure one will find the development of the 10-year rate for €-denominated European government bonds.

Figure 1.

In the graph we drew red vertical lines to distinguish the periods when interest rates rose from the periods in which interest rates fell. It needs to be noted that the bond is sensitive to the interest rate of the same maturity, now 20 years. That is not the same interest as the 10-year rate we used in the graph.

Structures and interest rate spreads

The longer the duration, the smaller usually the extremes in movements of interest rates will be. The development of long-term rates is an expression of the expectation of the markets as to the future development of short term interest rates. Market participants will always ask themselves whether the ECB and the Fed and other central banks will raise or lower interest rates in the (near) future. If one expects that interest rates will rise in the future, then yields on the long end of the bond market will lead the way by rising earlier. But investors also know that interest rates over a period of 30 years from time to time will drop again. At the peak of the interest rate cycle therefore 30-year yields will have risen less high than the 10-year rate. This is referred to as an abnormal, also called inverse situation. Normally, the 30-year interest rate should be higher than the 10-year bond yield as the risk that you will lose your money after 30 years is always higher than the same risk when having a term of 10 years.

Back to the graph in figure 1

What the graph does show is that an increase in interest rates will lose the bond investors money. If interest rates rise the price of the bond drops. This calls for a nuance. The price declines mainly take place in bonds with long to very long terms.

The graph also shows something else: the bond price is at a support level and a real breakthrough downward has not happened yet. The 10-year yield however has already broken through the resistance of 0.6%. Where 10-year yields rose further in recent weeks, the 30-year interest rate that did not.

And finally, the graph also shows once again that as yet no bottom pattern in the interest rate can be seen. To date, the tops again and again have been lower (lower graph) than the each previous top and bottoms and again and again came out lower than the foregoing bottoms.

The end of QE

But graphs are not everything. Last week an ECB member announced that he believes the European QE-program is nearing its end. And a member of the Fed in the U.S. went further by saying aloud that the Fed is close to the point to shorten its balance sheet. Virtually every analyst agrees that the European and American central banks face a normalization of their policies. In Europe, this means little in the short run, as Draghi has indicated that he will keep buying bonds until the end of this year. But the amount is less and whether he can continue this program in 2018 is becoming less likely. The Fed has already stopped buying loans, but so far has replaced the loans it has in its portfolio when they matured. Reducing the balance sheet means that they will also stop replacing loans. If that happens, then the potential inflationary risk from all that cheap money is reversed. After all, the Fed then pulls previously created money back out of the economy through the repayments on the loans it holds.

“When QE is stopped, interest rates will rise again”

That is the prevailing opinion amongst analysts. But whether this will be true is questionable. The expectation that the end of the QE program will lead to an increase in interest rates, is a self-fulfilling prophecy. If investors expect it, they sell long-term bonds, so the price of these bonds drops and thus interest rates rise. But then once the QE program is stopped and the central banks have cut their balance sheets again, it does not necessarily mean that the interest rate will keep on rising. For example, an increase in the velocity of money in the system would counteract the pressure on interest rates and could even make rates fall again. But if discontinuation of the QE-program is associated with an increase in inflation (and inflation expectations keep rising), then interest rates will probably continue to rise.

The development of interest rates is like the course of a supertanker

One should not expect interest rates to continue to rise for years in a straight line. The development of interest rates is as the momentum of a supertanker. It takes a long time before you have reversed the direction of a supertanker. One must therefore first expect the development of a large bottom pattern. And to this end it is interesting to look at US yields.

The 10-year yields in the $-sphere; long term trend

Figure 2.

Figure 2 shows two graphs on a monthly basis. The black graph, in the top, shows the development of the 10-year yield on US government bonds. And the blue graph at the bottom is the development of the 30-year yield on US Treasuries (CBOE). Line A, the red horizontal line in both graphs, is the most important line for the moment. It shows a considerable resistance, which has not yet been broken in both cases. This resistance coincides with the peak rate in 2015. It could well be that interest rates will go down again from this first level of resistance towards the bottom that was reached in both cases at the end of 2014. If this scenario manifests itself, we assume that the decline will take some time. This is a monthly chart; it can take several months before the fall has materialized. But we opt for a second, more likely scenario and that is that the current respite in the course of the next few weeks will be terminated with an outbreak upwards, with the interest rates rising to line B, the green horizontal line(s) in the figure. But then the supertanker again comes around the corner. From that level a sharp decline in interest rates is quite conceivable, back to the lows of 2012. Remember that Ms. Yellen is to be replaced by the end of this year!

Macro-economic reasoning

It’s speculation, but a reasonable macroeconomic scenario, which would explain our most likely scenario, is the idea that the Trump-administration will for a while keep-up the optimistic note of markets in general, but that in due course the chaos surrounding the Trump-administration will start to disappointment investors and will ultimately lead to an economic downturn or even a new recession.

Conclusion

Our first conclusion is that the supertanker is turning. Interest rates will ultimately turn the structural down trend into a long term uptrend in coming years, albeit in fits and starts.

Next week

And thus the next question is, how a bond investor can arm himself against an environment of structurally rising interest rates? The piece, that you have just read, is our introduction to this quest. Next week we will discuss some bond funds, asking ourselves whether they are or are not able to take advantage of rising interest rates.

The Hague, 24 February 2017
Gijsbrecht K. van Dommelen
Vladeracken Vermogensbeheer

www.vladeracken.nl

Disclaimer
The author is responsible for the investment policy at Vladeracken BV, an asset management company licensed by the AFM. Vladeracken invests and / or has invested in the securities discussed herein on behalf of its clients. This piece is not an investment advice. Whoever invests in the securities discussed herein and in accordance with the methodology and arguments discussed, or wants to invest accordingly does for his or her own accountability and risk. In this context, the author and Vladeracken BV disclaim all responsibility for the contents of this article. The securities and methods discussed represent a high risk.