Preparing for Day When Rates Rise; “We don’t subscribe to the view that once the fire starts, we’ll be able to outrun everybody through the door,”

March 10, 2013, 5:25 p.m. ET

Preparing for Day When Rates Rise

By MATT WIRZ

“Don’t fight the Fed” has been a market mantra for the past four years. But some bond investors are starting to lace on their gloves.

Figuring that the Federal Reserve won’t be able to keep a lid on interest rates forever, large money managers such as BlackRock Inc., BLK -0.08% TCW Group Inc. and Pacific Investment Management Co. are getting ready for the day when rates take their first turn higher.

It isn’t coming anytime soon, these investors say. But when it does, they worry, the ascent will be swift and steep.

Rather than trying to guess exactly when that moment will happen, they are pre-emptively making investments that will pay off when it does. The moves include buying debt with floating interest rates that rise as overall rates climb, as well as interest-rate swaps and inflation-protected bonds that will also increase in value.

Other investors are hedging against potential bond losses by making bearish bets on U.S. Treasury bonds through derivatives that gain when rates rise. As rates rise, prices of bonds fall. Because rates are so low now, many investors are worried that even a small rise could be particularly painful for anyone holding Treasurys.

“We don’t subscribe to the view that once the fire starts, we’ll be able to outrun everybody through the door,” said Stephen Kane, managing director for U.S. fixed income at TCW in Los Angeles. “Rates could be up 50 basis points before your traders can get all the sell orders through.”

Wagering on rising rates has mostly been a losing bet of late, thanks to the bond-buying spree the Federal Reserve began in late 2008. That has kept interest rates at rock-bottom levels. Ten-year Treasury yields, which hovered above 4% five years ago, have remained below 2.5% for the past 19 months.

But portents of painful losses came in January, when investors began worrying that the Fed might end its bond buying sooner than previously expected. Many investors rushed out of the government bonds, causing long-term Treasurys to lose 3.1% of their value in the first week of the year, wiping out their entire annual yield of 3% in a matter of days.

Upbeat news about employment Friday has helped stoke expectations that the economy is continuing to recover.

The fear is that as expectations of rate increases mount, short-term investors will bolt for the exits as prices drop, causing wild price swings and amplifying losses. The last such exodus took place in 1994, when Fed rate increases triggered a wave of selling that left 30-year bond prices down almost 24% in a year.

At BlackRock, Rick Rieder, co-head of fixed income for the Americas, has placed bearish bets on bond-futures contracts as a hedge against a rise in interest rates. As 2013 began, Mr. Rieder had sold bond-futures contracts valued at about $1.5 billion to protect his bond fund, which had $3.7 billion of assets at the time.

The hedge paid off when Treasurys sold off in January, when the BarclaysBARC.LN +2.94% Aggregate Bond Index, a widely used benchmark index for bond funds, fell 0.7%. The BlackRock Strategic Income Opportunities Fund gained 0.81%, according to Morningstar. The decision to hedge, and new investments, helped the fund’s assets grow to $4.6 billion as of March 8.

“For 30 years, interest rates had declined and fixed income was the safe part of the portfolio,” Mr. Rieder said. “Now fixed income is becoming something you have to be more active in.”

To be sure, the end of the Fed’s second round of quantitative easing in 2011 also pushed investors to bet interest rates would increase. The maneuver sometimes is called the inflation trade, because central banks raise rates to combat inflation. Bond bears suffered later in 2011 when turmoil in Europe and a third round of easing pushed rates on 10-year Treasurys down to less than 2% from 3.5%.

“I think it’s way too early to put on an inflation trade,” said Gary Pollack, head of fixed-income trading at Deutsche Asset & Wealth Management, a unit of Deutsche BankDBK.XE +1.81% AG.

And one popular way to protect against inflation, and rising rates—buying Treasury Inflation Protected Securities, or TIPS—is costing investors money. Investors have snapped up TIPS at government auctions, driving yields so low they have turned negative.

The principal on TIPS rises in line with the U.S. government’s consumer price index. But so far, inflation hasn’t picked up, leaving investors paying up for protection they haven’t needed. In addition, shorting Treasurys can be costly when rates drop. When yields on Treasurys began falling in February, Mr. Rieder’s fund suffered, lagging behind the Barclays Aggregate by half a percentage point that month, according to Morningstar. In late February, Fed Chairman Ben Bernanke reiterated his commitment to buying bonds, sending Treasury yields even lower.

While few bond investors have hedged against rising rates as aggressively as Mr. Rieder, some are starting to tackle interest-rate risk now. As a hedge, some investors are reducing duration, or the susceptibility of their holdings to a rise in rates. As interest rates climb, the value of existing bonds declines, and bonds with longer maturities drop the most.

The duration of TCW’s MetWest Total Return Bond Fund is 4.2 years, a year less than that of the bonds in the Barclays Aggregate, Mr. Kane said.

At Pimco, a unit of Allianz SA, ALV.XE +1.63% Managing Director Daniel Ivascyn said he has cut the duration of his $22 billion Pimco Income fund to 3.7 years at the end of January from 4.4 years at the start of 2012.

Individual investors who scrambled into bonds after the financial crisis shook their faith in stocks are also showing signs of nerves.

The four-week average of net inflows to mutual funds that buy floating-rate loans hit a record high of $1.2 billion in the last week of February, according to Thomson ReutersCorp.’s TRI.T -0.03% Lipper unit.

“I think people understand that higher rates are coming and that this time around [the rise] could be different,” said Shawn McClain, a managing regional director at Natixis Global Asset Management who sells investment products to financial advisers. “We don’t have a lot of cushion to absorb volatility if rates go up.”

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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