The Xchange Blog

Trading Debt in a Rising Interest Rate Environment

After more than a decade of a zero-interest -rate policy, the Federal Reserve has issued two quarter-percent rate increases within the last four months, bringing the federal funds rate up to 1 percent for the first time since 2008.

The Federal Open Market Committee’s (FOMC) projections indicate that the upward rate trend is likely to continue. In its March projection, the target range for 2017 among the majority of FOMC participants was set at a hawkish 1.375 percent, which would necessitate another two increases. Further, the 2018 participant projections weighted at or above 2.125 percent.

The growing pace of rate increases is particularly important to bond traders who, as interest rates rise, will see a decrease in yield and subsequent sale value of corporate and treasury bonds. As rates have been at all-time lows since the 2008 financial crisis, the bond market has experienced volatility in recent months in response to both rising rates as well as the increased value of securities that thrive on economic and market growth like stocks.

Because bonds act as loan certificates for which the bondholder receives fixed interest payments from the issuer, bonds are considered low-risk, high-liquidity assets compared to other investments. The value of a bond for an investor who intends to hold the asset until maturation never changes, so long as the issuer is able to pay back the loan. The low-risk nature of bonds often means that investors shift their portfolio to favor them in in times of volatility or economic uncertainty.

However, the price and yield rate of a bond changes if a bondholder intends to sell the bond before maturation, because bonds issued in a low interest rate environment will have a lower yield than those issued at a higher rate, and vice versa. Because interest rates are implemented as a measure to mitigate inflation in times of economic growth, the value of low-rate bonds are further lessened as investors weigh their portfolios with more reactive securities.

These forces have played out in a variety of ways since late 2016, particularly in the wake of the post-election market rally which saw ICE U.S. Treasury 7-10 and 20+ Year Bond Indexes fall sharply, the former by 6.2 percent and the latter by 9.8 percent, by December 16.

In 2017, much of the bond market’s activity has centered on the Fed’s movements, particularly the FOMC meetings held between January 31 and February 1 and the March 14-15 meeting in which the committee announced the second rate increase. Both of these events coincided with drops in the bond indexes and strong reactions from the Direxion Daily 7-10 Year Treasury Bull and Bear 3X Shares (TYD and TYO) as well as Direxion Daily 20+ Year Treasury Bull and Bear 3X Shares (TMF and TMV).

Other events, such as inauguration day on January 20, as well the resignation of National Security Advisor Michael Flynn on February 13, marked moments where feelings of political uncertainty manifested as volatility in the bond indexes.

While the current ecosystem of rising interest rates and steady economic activity may make bonds less appealing to some investors, rising rates mean that, long-term, bond yields will tend to rise. That may not mean much in the short-term interest rate environment, but tactical managers should consider those yields when weighing the role of bonds in their own portfolios.

The yield tables below reflect the negative impact to returns in a rising rate environment. Inverse ETFs may be used to mitigate this risk.


Source: Bloomberg. Past performance is not indicative of future results.

A bullish take on bonds—meaning inflation will increase leading to a more favorable bond environment—would make the Direxion Daily 7-10 Year Treasury Bull 3X Shares (TYD) and Daily 20+ Year Treasury Bull 3X Shares (TMF) potential opportunities.

If you’re on the bearish side—meaning you think inflation will not accelerate, which will encourage continued accommodative monetary policy and therefore a less stable bond environment, the Direxion Daily 7-10 Year Treasury Bear 3X Shares (TYO) and Direxion Daily 20+ Year Treasury Bear 3X Shares (TMV) can be used. Keep in mind these instruments are designed for traders who understand short-term volatility and how leverage can affect returns.

 

Related Funds