- I believe rates will rise this year. If rates rise, these ETFs will profit.
- The market can be flat or plunge and these ETFs don’t care. They have virtually no correlation to gyrations of the US stock market.
- In fact, during this recent interesting and volatile period, each has gone up a bit, not down.
- I believe this rise is just the beginning.
There are many investment choices in the marketplace that have nothing to do with the companies traded there. Some of these have a zero or negative correlation with the stock market, which in times of severe volatility and turmoil makes them worth considering solely for that reason. However, when they also offer a profit if something that is far more certain than the short-term direction of the markets is their “bread and butter” they are truly worth our attention.
No one knows what the market is going to do tomorrow, or next week, or next month. If you ask me that question, I will answer as J.P. Morgan did a century ago: "It will fluctuate." We have seen ample evidence of that of late.
However, I have identified a few ETFs that have nothing to do with the market’s direction. I have kept my finger near the button for over a year now, waiting until I believed the time was right to pounce.
I think it’s time. I have been researching companies and funds that fit the big themes I expect over the next few months, regardless of what the equities markets do, and these fit perfectly.
Everyone has an opinion of what the stock markets are most likely to do in the coming months. But expert opinions and a dollar still won't buy you a cup of coffee at Starbucks (NASDAQ:SBUX). I am instead seeking investments that do not depend upon a rising market -- or anyone's opinion -- right now.
What I know as fact, not opinion, is that the USA is quickly reaching what economists consider full employment. Full employment means wage increases as companies scramble to attract talent. Wage increases mean inflation, and inflation means the Fed will continue its aggressive net selling of bonds and will raise rates. When they do, bond yields will rise and the bonds themselves will decline. (By the way, I use the term “net selling” for a reason – the Fed doesn’t have to actually sell bonds from its portfolio; it can simply let each tranche mature and then not replace it with normal rollover buying. The “net” effect is the same.)
That's why I am buying two inverse ETFs on US Treasury bonds. These are not like the potentially dangerous inverse equity funds, which reward you if stocks decline but punish you if stocks soar. These ETFs move slowly, but I believe their rise will be slow, steady and certain. The ProShares Short 20+ Year Treasury (NYSE:TBF) and ProShares UltraShort 20+ Year Treasury (NYSE:TBT), a 2x leveraged short, are two that I believe are destined to do well.
TBF’s approach and portfolio are the pinnacle of simplicity. Instead of holding long-dated US Treasury bonds, this ETF has entered into Treasury Index Swaps with investment banks like Societe General, Citibank, Morgan Stanley and Goldman Sachs. These swaps give them the opportunity to sell back positions to these investment banks at a profit if the bonds fall.
What is in it for the investment banks engaging in the swap? They receive all the interest on the bonds and, effectively, a fee from the counter-party to the swap. Their bet is that rates will not rise too far or too fast. (This is actually more complicated than a simple “fee” arrangement. One party wants to, in effect, buy the difference between a fixed rate and the rate it changes to over time and the other party wants the certainty of a fixed return. Think of it as a fee or Google “swaps” or “interest rate swaps” and you’ll see enough verbiage and graphics to make your head swim!)
This allows ProShares, the issuer of this ETF, to benefit if rates rise (or suffer if rates fall.). As new debt is created at higher rates, these older Treasury bonds, to remain relevant, must pay the same effective yield. If they can’t, and they can’t (change the terms of the existing bonds,) the price of these older bonds in the portfolio will fall to equal yield available on the newer debt.
I think those who believe rates will rise only slowly are overlooking the massive amount of Treasury and agency bonds that are being disgorged as the US Fed reduces its holdings of older bonds. Even without considering an actual rate increase, this supply is already weighing heavily upon the demand for secure income.
That’s why I like choice #2, ProShares UltraShort 20+ Year Treasury (TBT), even better. It is riskier, of course. If I am wrong and rates go down, this ETF should decline at twice the rate of its sister fund. If I am correct, of course, it should rise at roughly twice the same rate. The portfolio is also simplicity itself. The fund has simply taken a double helping of Treasury bonds and, in this case, added Bank of America to its list of corresponding friendly bankers.
The investing theme here is the very model of simplicity. If US interest rates decline, these funds will lose value. If US interest rates rise, these ETFs will rise as well.
One other thing. There is always “erosion” to consider when buying inverse ETFs or open-or closed-end mutual funds. As a result of daily marking to market and the small fees involved when entering a swap, such funds will decline minutely more than they will increase with a corresponding change in bond yields. That is why I have had my finger near the button to buy these for nearly a year now but have not pushed the button until now. I think the erosion factor amounts to decimal dust compared the potential return.
Just what might that return be? I am indebted to my colleague of many years, Gray Emerson Cardiff, the estimable editor of Sound Advice one of the best-performing (and best-written) financial newsletters in the business, for having prepared the following analysis. He has recommended these two as well as one other for his subscribers.
Assuming no rapid increase from what the Fed has already indicated, Mr. Cardiff has projected that long-term Treasury bonds might reasonably yield 3.96% by the end of 2018 and 4.52% by the end of 2019.
Under this conservative scenario, TBF, the unleveraged inverse fund, would climb from its current $23.43 to $26.86 by December and to $29.28 by December 2019. A 14.6% return over the next 11 months may not sound very impressive to investors spoiled by the returns of the past couple years. However, I don’t suggest this investment as a replacement for riskier investing but rather as an adjunct to your portfolio via an ETF I see as a more dependable choice for gains.
As for the 2x leveraged TBT, the numbers look even better. Using the same scenario for interest rates, at the end of 2018 the fund, currently at $38.73, would rise to $50.75 by the end of 2018 and to $60.31 by the end of 2019. For me personally, I believe the extra risk that the leverage entails is well worth the opportunity to make 31% on an investment that does not depend on the stock market advancing, but only upon the likelihood of rates rising.
As always, do your due diligence. And if you have other alternatives with a no or low Beta to US stock markets, please share your thoughts. I am always ready to discuss new ideas.
Disclaimer: Do your due diligence! What's right for me may not be right for you; what's right for you may not be right for me. Past performance is no guarantee of future results. Rather an obvious statement, but too many people look only at past performance instead of seeking the alpha that comes from solid research and due diligence.