Interest Rate Risk
The interest rate market is a global market which affects consumers, borrowers and lenders worldwide. Interest rates affect consumers on a retail level as they influence credit card purchases, home loans, business loans, as well as investments that pays a fixed rate. On the institutional level, interest rates are the key components in which large institutions fund their daily cash flow. Loans between banks as well as overnight loans to large corporation allow companies to fund their daily liabilities. This article will examine the interest rate markets, and discuss some examples of liquid interest rate ETFs.
Interest Rate Markets
The debt market is a global market as well as a local market. Most investors view interest rates as the rates in which a sovereign government borrows money. In general, these are the most liquid interest rates, but are far from the only rates traded in the global market place. There is debt issued by municipalities, debt issues by corporations, and debt issued on homes and cars.
Interest rates move as a function of monetary policy and market forces. Monetary policy is the process by which the monetary authority of a country, which is usually the central bank, controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability.
The official goal of monetary policy includes dual mandates such as relatively stable prices and low unemployment. In other countries the focus is solely on price stability. Monetary theory provides insight into how to manage optimal monetary policy. It is referred to as either being expansionary or contractionary.
Central banks will be dovish in times when growth is slow and prices are stable, and in turn will lower rates. Central banks will be considered hawkish when growth is robust and prices are rapidly moving higher. In these times the monetary authorities will increase interest rates. By changing interest rates, the central banks are changing the levels at which banks lead to one another as well as, the rate at which they will lend to banks. In the US for example, this rate is called the Federal Funds Target Rate, and the discount rate respectively.
The changes that a central bank makes to the Federal Funds rates (in the US for example), will generally only effect short term interest rates. Longer dated rates are influenced by market forces. This means the rates at which the US government can borrow for 2-5-10 and even 30 years will be created by “the market”.
Portfolio
Interest rate exposure is inherent in any portfolio whether the manager has fixed income products as part of the portfolio, or only equities. In a case where a portfolio manager has a fund of only equities or commodities, the profits or losses within the portfolio are subject to changes in interest rates.
Revenue and liabilities that are produced in a portfolio that are not due for payment until a date in the future are discounted to reflect the current interest rate for the time. This is referred to as the net present value of a portfolio. For example, if a portfolio manager has a trade that has profits which are due to the investor in two years, the portfolio managers has exposure to 2-year yields. If the yields increase, the revenues will theoretically decrease. Future realized and unrealized gains are subject to fluctuations due to changes in the discount function or current interest rates.
Obviously if a portfolio managers has interest rate products within a portfolio, these products will fluctuate in value based on overall market movements of interest rates.
Changes in Rates
Changes in interest rates are generally described by the change in a basis point which is 1 thousandth of a percent. There are 1000 basis points for every percent change in a yield. When describing the interest rate risk of a portfolio or financial instrument, the nomenclature refers to the dollar value per basis point, which is commonly written as DV01.
Duration
The term duration is a measurement of the time scale of cash flows related to a bond. Longer durations of interest rate products correlate to higher exposure to interest rates. Rising interest rates mean falling bond prices, while declining interest rates mean rising bond prices. The bigger the duration number, the greater the interest-rate risk or reward for bond prices.
Convexity
Convexity is a measure of the sensitivity of the duration of a bond to changes in interest rates. Price convexity is a second derivative of the price of the bond with respect to interest. In general, the higher the convexity, the more sensitive the bond price is to decreasing interest rates and the less sensitive the bond price is to increasing rates. Bond convexity is one of the most basic and widely-used forms of convexity in finance.
Speculating and Hedging Exposure
Theoretically, there are two main reasons that a portfolio manager initiates an interest rate position. The first is that the manager is attempting to take advantage of a directional or spread interest rate move in the market. This could be because of relative value or technical analysis, but for whatever reason the manager is looking to initiate a position in the debt markets. The second reason is that a manager is looking to hedge or mitigate interest rate exposure and offset a position with a new position.
To initiate a position, investment managers could purchase or short an interest rate product, such as a bond or swap or futures contract or ETF. These products generally move higher as interest rates move lower, and lower as interest rates move higher.
When hedging an interest rate position, a manager will generally calculate their DV01 and look for a financial instrument that could offset this exposure. Many managers use futures contracts or swaps to offset interest rate exposure. Most hedging cannot be offset complete, which create a basis exposure for a portfolio.
A basis risk is a risk in where the exposures to interest rates are not identical. For example, many banks and investors purchased peripheral European risk prior and during the issues related to the EU debt crisis. To hedge this exposure, many investors sold German bonds in an effort to offset some of their interest rate exposure.
Some of the most popular US government interest rate ETF’s include:
- iShares Barclays 20+ Year Treasury ETF, TLT
- ProShares Short 20+ Year Treasury ETF (TBF), which is the inverse of TLT
- ETNs
- iPath US Treasury Long Bond Bear ETN (DLBS)
- iPath US Treasury Long Bond Bull ETN (DLBL)