Simply purchasing long puts on ETFs that invest in U.S. Government paper allows the buyer to profit from rising interest rates and falling bond prices. While speculative, this is not a particularly risky strategy (compared to short-selling) because, as with long call options, possible losses are limited to the amount the buyer pays to buy the option contracts. Simply put, one cannot lose more than one puts it. In a Wall Street Journal article entitled “Bond Investing May Soon Have a New Math”, Tom Lauricella reports on several new debt funds which seek to “make money already when interest rates rise–consequently, when bond prices are falling.” (Lauricella C7) Lauricella mentions several funds including Goldman Sachs Strategic Income, Loomis Sayles Absolute Strategies, and JP Morgan Strategic Income Opportunities.
In what amounts to a cautionary observe to would-be investors, Lauricella says that “…these funds bring with them a large number of unknowns [because] their strategies have never been tested by a meaningful rise in interest rates [and] their complexity…makes it difficult for investors to know what the funds are investing in and to estimate their risks.” (Lauricella C7) Tom is not kidding. In the prospectus for JP Morgan’s Strategic Income Opportunities fund, clients are advised that the portfolio manager uses six “strategy allocations” to manage the fund, including “relative value strategies” which “seek to adventure pricing discrepancies between individual securities or market sectors…[using] (1) credit-oriented trades such as purchasing a CDS related to one bond or set of bonds and selling a CDS on a similar bond or set of bonds, (2) mortgage-dollar rolls in which the Fund sells mortgage-backed securities and the same time contracts to buy back very similar securities on a future date, (3) long/short strategies such as selling a bond with one maturity and buying a bond with a different maturity to take advantage of the provide/ return between the maturity dates, and (4) other combinations of fixed income securities and derivatives.” (all from JP Morgan’s Strategic Income Opportunities Fund Prospectus–the.pdf can be found at http://www.jpmorganfunds.com)
Now if all this is starting to sound complicated, that’s because it is. In fact, it is unnecessarily complicated. Using Credit Default Swaps and mortgage-dollar rolls to unprotected to gains in debt funds when interest rates rise seems like overkill. In his article Tom Lauricella explains that “credit default swaps…are essentially insurance policies against a bond issuer defaulting on its payments…[and] have become a shared tool among…different mutual funds for betting that a bond’s price will decline.” (Lauricella C7) While CDSs surely offer specialized money managers a high level of flexibility as far as which individual bonds they bet against, there is simply no need to use complicate strategies to bet against the bond market. JP Morgan’s Strategic Income Opportunities Fund charges investors an upfront load (read: fee) of 3.75% plus a total annual fund operating expense of 1.13%. Thats a total of 4.88% in fees during the first year an investor is in the fund! If the fund doesn’t return at the minimum 5%, the investor truly loses money in the first year. Investors then, are paying for JP Morgan to chase returns in the fixed income markets by implementing complicate derivative-based strategies which seek to capitalize on “price discrepancies between individual securities” (JPMorgan Strategic Income Prospectus)
To be fair, the Strategic Income Opportunities fund also utilizes five other strategies in pursuit of superior returns–I only single out the “relative value strategy” as a way of demonstrating the complicate character of these new debt funds. Also, JP Morgan is only one company among many who are rolling out these funds, and if past performance method anything, I’m sure JP Morgan’s fund will rank among the best in this new class of bond funds. Having said that however, there is no reason why investors should expose themselves to complicate strategies and high fees simply to bet on falling bond prices. All an individual has to do is buy long puts on Fixed Income ETFs.
The only fees that will have to be paid are those charged by the broker to execute the transaction. It will surely be argued that this approach is not nearly as nuanced as that taken by the specialized managers of the new different strategy debt funds. While this is no doubt correct, for the average investor, there are plenty of Bond ETFs to bet against. For example, one can buy long puts on iShares Barclays 20+ Year Treasury Bond Fund, iShares Barclays 1-3 Year Treasury Bond Fund, SPDR Barclays Capital International Treasury Bond Fund, and/or iBoxx High provide Corporate Bond Fund. All of those ETFs have options which would theoretically allow investors to bet against long term treasuries, short term treasuries, international government debt, and investment-grade corporate debt respectively. If these options aren’t enough there are plenty more. Why pay an expensive fee to make a bet that you can make on your own in a manner that is cheaper and easier to understand?
Lauricella, Tom (2011, July 6). Bond Investing May Soon Have A New Math. The Wall Street Journal, p. C7.