29 June 2004, Investment Advisor

Investing in a rising interest rate environment is a tightrope act. While bonds are paying more, their prices will continue to get smacked around until the cycle peaks. When that will be is of course the great unknown, making fixed-income investing part guesswork and much dollar-cost averaging.

The last two times the Fed went into tightening modes, in 1994 and 1999, the Lehman Brothers US aggregate Bond Index [price ex coupon] took it on the chin, ending the years down 9.5 percent and 7.0 percent, respectively. And such prospects are sending some investors fleeing, according to Lipper, who reported a net outflow of $17.5 billion from bond funds in May–the largest ever recorded by the fund data tracking agency.

Rising rates aren’t likely to treat stocks much better. The S&P 500 rose a paltry 1.3 percent in 1994. Bubble-happy equity investors kept the party going in 1999 despite continuous rate increases, ending the year up 20.9 percent. But what followed for the next 3 years was as ugly as it gets.

“And now, between the Fed first pronouncing fear of deflation, then turning 180 degrees and sounding inflation alarms,” explains Mark Foster, 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 because of renewed demand and growth, which means more people are working, that pricing power has returned, and profits are rising. And even if the fed pushes up rates by 200 basis points by the end of 2005–which is the general consensus–that still leaves rates at growth-sustaining levels.

In a recent BusinessWeek survey of 34 economists, most believe “higher interest rates may not be a big constraint because the extended window of low-cost financing and strong sales growth have left companies so flush they don’t need to borrow much as cash flows have risen above capital spending needs.”

So why the chicken little scenario?

Because, over the short-term, as rates begin to rise, making money in the markets is very difficult.

According to Sam Stovall, Standard & Poor’s chief investment strategist in New York, stocks don’t do very well 6 to 12 months after a series of rate hikes is initiated. Citing six up cycles since 1970, Stovall found that the broad market fell on average five percent six months after initial monetary tightening began. And after a year, the index was off an additional percentage point.

A few sectors did hold up. Information technology rose seven percent one year into the rate increase, and Health Care wasn’t far behind, having appreciated five percent.

But what shocked the bejeebers out of Stovall was that 55 of 56 industries tracked by S&P fell during the first six months, suggesting that no one will escape the reckoning unscathed.

What Then to Do

First and foremost, advisors shouldn’t be thinking of radical asset reallocation. “A well-balanced portfolio,” posits Steven Saker, vice president 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. However, advisors should always be mindful of making course adjustments as new risks and opportunities present themselves.”

Below are several high-grade, lower risk strategies that may help investors sidestep some of the hazards of a secular rate rise, and in a few instances, exploit it. As is common with most recommendations, phasing into positions through dollar-cost averaging should further mitigate risk.

1. Laddering bonds

Hardly an epiphany that managers should spread fixed-income exposure across various maturities to mitigate risk and enhance returns when rates start rising. While producing modest yields, shorter-term paper will have minimum volatility due to pending repayment. And a consistent flow of maturities enables reinvestment in higher-yielding debt. While potentially more price sensitive, exposure to longer-term debt helps bump 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, CT investment management firm, expects fed fund rates to peak at 4.25 percent and 10-year yields to top out at around 5.75%–levels which he suspects will be sufficient to slow down economic expansion without threatening growth. So he will phase his investments as rates approach these targets.

2. Inflation Protected Securities

Treasury Inflation-Indexed Securities [aka TIPS] appear to take a lot of the guesswork out of timing the market. Presuming inflation is on the rise, TIPS will capture the change in CPI within its principle, helping these bonds to sustain their value despite rising interest rates. Though the coupon remains constant, increasing bond values help generate higher yields.

Bill Davison, managing director at the Hartford Investment Management Company which has $830 million invested in TIPS, found that year-to-date through 22 June, total returns on four-year fixed-rate Treasuries declined 83 basis points due to rising rates. Comparably maturing TIPS gained 1.9 percent because of the inflation accrual and greater price stability.

Believing inflation and 10-year Treasury yields will likely rise an additional 100 basis points over the next 12 months, to 3.75 percent and 5.75 percent, respectively, Davison thinks TIPS will continue to provide upside protection.

Since their inception in 1997, TIPS have done well in both bear and bull markets. The Lehman Brothers TIPS index has outperformed every other major bond and equity index during the recent bear market between 2000 and 2002, enjoying total annualized returns of 12.49 percent. And even after stocks and bonds rallied last year, the index sustained its 3-year annualized lead through 2003.

However, some managers think TIPS have become too expensive.

Because they offer inflation protection, TIPS’ coupons are normally less than nominal 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, up from 2.50 percent in April to 2.67 percent in June. That 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 nominal Treasury investor.

Varun Mehta, portfolio manager of Milwaukee-based Mason Street Advisors $170 million Select Bond Fund, is currently phasing out his position in these securities because after a very good run, he doesn’t believe their returns will continue to outperform nominal Treasuries.

3. Inverse Mutual Funds

If you think yields of the 30-year Treasuries are going up, Rydex’s Juno Fund and Profunds Rising Rates Funds will profit by shorting these securities.

Investor interest in the 10-year old Juno Fund [RYJUX] has recently soared with assets having risen from under $100 million in 2002 to over $3 billion as of June 2004. “Although created for market timers and speculators,” explains fund manager Anne Ruff, “financial advisors increasingly rely on the fund to protect bond profits unrealized over the past couple of years.”

Year-to-date through May, Standard and Poor’s reports that the fund is up 1.29 percent, bettering the Merrill Lynch Corporate & Government Master Index by 1.87 percent. However, over the past 3 and 5 years, the fund has underperformed the broad bond index by 14.12 percent and 11.37 percent, respectively.

To be in the black, the Juno fund has significant costs to over come. When shorting a Treasury, explains Ruff, you have to pay the owner the current yield, which on the 30-year issue is currently 5.38 percent. This is partially offset with assets kept in an overnight repurchase agreements that currently pay 1.85 percent. The net carry expense is therefore 3.53 percent. Add to that the fund’s annual charges of 1.41 percent, and that means the fund must earn virtually five percent 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] is a leveraged, more risky version of the Rydex fund, providing 125 percent inverse exposure to the 30-year Treasury. This means that the fund should appreciate 1.25 times the amount that Treasuries decrease. Barely two years old with $679 million in assets, fund performance year-to-date through May was up 1.56 percent, outperforming the Merrill bond benchmark by 2.14 percent.

Given the costs inherent in shorting Treasuries, the fund’s 1.57 expense ratio doesn’t make things any easier. But if one suspects interest rates are going to return to their historical mean, both funds should provide a unique means of profiting from rising rates. However, once rates start coming down, you won’t want to be in either.

4. High-flying Large-Cap Growth Stocks

Higher interest rates reduce equity valuations and make bonds more attractive. However, an alternative to shying away from the 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 E-Bay and Stryker likely do.

Despite the protracted tech collapse, E-Bay’s shares are up at an annualized clip of 18.29 percent since June 1999. And even with the stock climbing 34 percent year-to-date through mid-June and weighed down with increasingly more challenging comps going forward, E-Bay’s business model remains the paradigm of the New Economy.

JP Morgan’s NY-based tech analyst Imran Khan projects 61 percent EPS growth for this year followed by 33 percent for 2005. He explains “better than expected revenue growth and improving margins should lead to multiple expansion.” And Goldman Sach’s Anthony Noto, also in New York, thinks shares are likely to continue to thrive “over the short- and longer-term given growth running at nearly twice the industry rate.”

A play on the developed world’s aging demographics, shares of global medical products maker Stryker have soared at annualized rate of nearly 29 percent 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 percent earnings growth for more than 20 years.”

Merrill Lynch’s Katherine Martinelli projects this growth rate to continue in 2004 and 2005. And with the company being essentially debt free and sporting a multiple that’s among the highest in our coverage universe, Martinelli speculates that a future earnings driver could be a significant acquisition.

5. Preferred shares

New York Stock Exchange-traded preferred shares are debt-like securities that many advisors know little about. Like bonds, their prices tend to move inversely with interest rates. The good news, however, is that they often yield 100 basis points or more over comparably-rated debt because they are less liquid than bonds, subordinated to senior paper, and many don’t mature. And near-term call dates can help support price levels when interest rates are rising.

Kevin Conery, preferred stock strategist at Merrill Lynch in New York, found a Citigroup AA-rated 10-year bond with a current yield of 5.80 and a series Z preferred share paying out 6.97 percent. Callable as of September 2006, and trading slightly under the call price of 25, the preferred’s yield-to-call would be 7.08 percent.

The preferred market experienced a major correction in April when the fear of rising rates generated a negative total return of 4.64 percent on the Merrill Lynch Master Preferred Index–the single-worst monthly performance since January 1990.

May witnessed further erosion in prices until investors began to seeing bargains, which stabilized demand.

Toward the end of June, Royal Bank of Scotland, among the largest issuers of dollar-denominated preferred [with no foreign exchange exposure] have two series, G and H, which may be called from month to month, now selling below the call price, offering current yields of 7.4 and 7.26 percent, respectively.

If these shares don’t get called, investors will be collecting very attractive yields. There is a risk, however, that if the market expects rates to rise, the price of these preferreds could continue to decline because substantially higher borrowing costs may keep the bank from refinancing these issues.

If the shares do get called soon, unlike bonds, the latest dividend goes entirely to the holder of record.

Even more enticing about preferreds like the RBS series is that their dividends are taxed at the new low 15 percent rate. However, Wall Street has developed a breed of trust preferreds–including the Citigroup issues–which are backed by bonds and therefore pay interest that’s taxed at ordinary rates.

6. High-Divided Yielding Large-Cap Foreign Bank Stocks

Bank shares usually take hits when interest rates increase because the spread between existing long-term loan rates and the cost of new money shrinks. However, in a number of major markets, interest rates have already cycled up well ahead of the US, suggesting that such shares have transitioned past a vulnerable stage. Trailing one-, three- and five-year performance through April revealed sustained value along with increasing dividends that consistently pay four to five percent. Advisors need be mindful that ever-fluctuating exchange rates affect yield and total returns.

Australian overnight rates are up 100 basis points since mid-2002 to 5.25 percent. But over the past 12 months through mid-April, the country’s six largest banks have seen their stocks rise an average of 25 percent in local currency terms. Going back to April 2001, annualized price returns averaged 15.69 percent. Three of the banks–Westpac, ANZ, and NAB–have ADRs that trade on the NYSE. Commonwealth Bank of Australia, Macquarie Bank and St. George Bank trade only locally.

UK interest rates have been among the most stable around, moving within a 50 basis point bandwidth since end of 2001. However, starting in the fall of 2003, rates have shifted up from 3.5 to 4.5 percent, with many observers expecting additional monetary tightening. Still, the five UK bank shares–HSBC, HBOS, RBS, Barclays, and Lloyds–rose 9.89 percent over the past 12 months through April. But over the past three years, these shares have realized annual gains of 13.28 percent. Of the group, HSBC, Barclays, and Lloyds have ADRs.

What’s ahead?

UBS’ London-based banking analyst Christopher Ellerton believes that banks’ increasingly risk-adverse lending policies of 2002 and 2003, 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. And he sees profitability and capital position strengthening in 2004 and 2005.

7. Foreign bonds

We highlighted the merits of looking overseas for higher-yielding fixed-income plays in the April issue of the magazine and 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 the United Kingdom than they are here. That means more yield and less capital risk.

keen on short- and medium-term UK and New Zealand sovereigns.   As of 14 June, US 1-year Treasuries were yielding 2.14 percent and three-year bonds 3.4 percent.  British gilts were paying 4.61 and 5.16 percent, respectively, while New Zealand government bonds paid out even more, yielding 5.93 and 5.98 percent, respectively.

Advisors should also look into inflation-protected sovereigns. While the international market is less liquid than the states, real yields in more than half the nine countries that offer these securities exceed those paid by TIPS. Barclays Capital noted that in June, Australian securities were not only yielding 132 basis points more than US 10-year TIPS, but the country had higher expected inflation–2.5 versus 2.1 percent–which would further enhance Australian yields.

The main risk of investing in foreign bonds is currency exposure. As of June, the dollar has temporarily stemmed its two-year slide. But many FX analysts predict this is just a lull and expect the country’s record current account, trade and budgetary deficits to force the dollar down quite a bit further. And if this occurs, foreign currency exposure will further sweeten returns, making itself an asset class worth looking at.

8. Foreign Exchange

The prospects of higher US interest rates should boost the dollar. And it may, even as other major central banks tighten monetary policy. However, Lehman Brothers currency analyst Jim McCormick thinks the dollar might very well sink lower.

“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 and stabilized and began its sharp ascent only after rates had steadied. Despite repetitive rate cuts that brought the Fed fund rates to 46 year lows, the dollar only began its present slide after the Fed was virtually done cutting rates.

Accordingly, McCormick believes that “US 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 towards 6 percent of GDP.”

As explained in the October 2003 issue of the magazine, investors can gain foreign currency exposure through a variety of methods. The easiest is buying country-specific ETFs, ADRs or fishing directly in local foreign bourses. With a number of foreign large-cap companies paying dividends ranging from four to five percent and foreign sovereigns offering comparably attractive yields, sitting in such securities provides cash flow and for investors waiting for the dollar to weaken.

For more sophisticated players, there are also currency options and futures. But perhaps a more secure way to play these investments is through Commodity Trading Advisors.

CTAs are hedge-like funds designed largely for qualified investors with very large minimum investments. Some advisors have partnered with major brokerages, like Merrill Lynch and Morgan Stanley that offer access to smaller retail investors.

Campell & Company’s Financial Metal and Energy Portfolio [largely a financial play with half of its $7 billion assets in currencies, one-quarter in interest-rate instruments, and 16 percent in financial indices] is available through dozens of brokerages, with minimums of $100,000 and less. Its annualized five-year returns, net of expenses, through May 2004 was 11.1 percent versus a -1.53 percent for the S&P 500. At the same time, its standard deviation was 14.29 percent versus the 16.7 percent for the broad market.

The attractiveness of these funds is that they can profit regardless of which way exchange and interest rates are heading. Volatility drives their success. However, their effectiveness is blunted when markets are trendless, as they have been for much of 2004 through June. Moreover, expenses are not low. So if you want to play in the rarified air of currency trading, you got to pay the piper.

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There’s always the possibility that rates may not be heading substantially higher. Growth may falter because of exorbitant fuel and commodity prices, record federal and trade deficits, the Iraqi War, terrorism, and overextended consumer credit and refinancing.

So even if the sky isn’t falling, odds are it will descend a bit and that we are in for an extended ride up the yield curve. And if that happens, the above strategies could likely add a bit of alpha during a time in which most portfolios will be struggling.