0

I now have around $150k invested in a few mutual funds, whose holdings are mostly international and and investment-grade corporate bond. Now those funds are down 15% since the federal rate hike and their value won't recover until rate drops again.

Recently I find most of my investment rely heavily on the fed's rate drop, which is a bit concerning, so I want to hedge on the possibility of a continued high rate platform or even a continued rate hike with my future investment.

Right now I have $150K in bonds (mutual funds) that are almost net-zero, i.e. 2 years' of dividend neutralized by 2 years' price drop. And another $40k in cash that I want to invest without betting on a rate drop. I don't have mortgage or any other debt.

I really couldn't think of any instrument that increases in value with federal rate hike, except for options and futures, because it's money itself that increase in value during rate hike. So should I just hold cash? Alternatively, what instrument increases liquidity with rate hike? Still cash?

Update: Now I thought about it more, high yield savings and short-term CDs may be the best solution for me, especially the short-term CDs. Right now yield curve is so inverted that short term CD's rate is very competitive. Also for it's short-term, maturity is so close that it's not relying on the secondary market, hence indifferent to the change in market price.

related: Are inflation protected bond funds a hedge against rate hikes?

5
  • For funds you expect to use soon, or that are your "emergency fund" buffer to avoid having to cash out shares during a stock market dip,, yes, CDs (perhaps as a CD ladder) and high-interest savings accounts are very reasonable choices. Lower but not unreasonable return traded against much lower risk.
    – keshlam
    Sep 16, 2023 at 13:31
  • 1
    Hedging costs money, either directly (buying options) or indirectly (opportunity cost). You might consider some inexpensive put spreads on a liquid bond ETF. It won't hedge 1:1 but it will take a lot of the sting out of further loss of principal. Sep 21, 2023 at 2:05
  • @BobBaerker That's what I have thought, too. I have some experience with options as gambling but none as a hedging tool. I doubt I had the proficiency to not lose money there. I'll do more research and try it a bit. Sep 21, 2023 at 3:15
  • 1
    @user3528438 - There are a variety of ways to hedge long positions: short equities or futures, sell covered calls (a poor hedge), buy puts. At times, I put on a a 10% wide bear put LEAP vertical that is 10% out-of-the money (market hedge). It's throwaway money (all insurance costs something). They're not very expensive and with some occasional trades, the cost can be lowered, sometimes close to free if the market cooperates. And later in the year, short puts can be covered for peanuts, leaving only long puts. Sep 22, 2023 at 19:38
  • cont: In 2020, I had leftover March SPY puts expiring in less than two weeks that were worth maybe 15 cents. Then Covid hit. I sold them from $15 to $20 each. When the market was down 35%, I was done maybe 7-8% despite having a number of 1,000 share positions in large caps that were down 50+ pct. Read up on it and determine what, if anything suits you. Sep 22, 2023 at 19:39

2 Answers 2

1

Sounds like you're suggesting substituting in short term rate exposure (presumably so you're not trapped further on the longer end of the yield curve). Here are some other points to contrast or complement.

With CDs: the secondary market can offer a way to become familiar with the liquidity of the instruments. Improved ability to liquidate or borrow against the assets could ease future personal and market circumstances. (Other factors like solvency risk and pricing quirks could also play a role in choosing the secondary market for achieving a return from CDs.)

Borrowing to fund a productive investment: If rates for the selected maturity continue to rise, the loan value will be lower (all else equal), potentially preserving the ability to repay a smaller amount absent the rate increase (and/or to have an improved financial position in the meantime due to the smaller outstanding balance). Adventurous spirits might borrow at a longer duration to buy shorter-duration assets.

"Borrowing" can include using derivatives (as you mentioned): for example, replacing long equity-like exposure with leveraged exposure (eg, using futures or options) so that the implied interest value in the position remains higher than it would otherwise. An example would be replacing a $30,000 equity position with a $10,000 futures or options exposure dated for 18 months (but of course you still face more rate risk whether you invest the remaining $20k at a duration of 5 years or 6 months)

Tailored instruments: like interest rate futures which could offer ways, for example, to "insure" a $100,000 notional value bond portfolio from interest rate changes. One could go long a yield futures or short a US Treasury futures which can add/remove cash from your account daily for the change in value. Similarly, fixed income ETFs may provide tradable mechanism for the exposure. One might add more tuning by trading options on these products (eg, using puts instead of shorting a dividend ETF, etc).

Correlations: Also you could enter/adjust other positions you believe are merely correlated with rates (e.g., if you believe a heightened risk of job loss may co-occur with increased rates, you could hold more cash, pay for skills training, etc.)

Orthogonal positions: You could also add an income source by shorting volatility (eg, instead of shorting US Treasury futures, selling call spreads on the futures). This is probably not appropriate for most use cases, but it can be another way to adjust the risk/return profile of the portfolio. Also, various instruments like credit default swaps, equity, convertible notes, etc, could provide ways to address specific potential events or risk in names in your existing portfolio.

"Doing nothing": Sometimes it's best. But it can also help simply to calculate the expected value of "doing nothing", for a month or two (for example), even if only to set a benchmark for what level of return you believe you should get and the time value of waiting. For example, I might want to know that $40,000 generates about $180/mo at current short-term riskless rates to quantify the cost of waiting and set a benchmark expected return.

Regarding liquidity: Contractual requirements to be paid under specified conditions provide one way to help ensure liquidity. This includes "laddering" bonds or other assets by maturity and possibly paying for American style puts which you can exercise early. If you have a contractual agreement with your broker to borrow against your bonds and CDs (a margin agreement), that can provide additional liquidity compared to alternate ways of holding those assets. But the broker may offer no contractual agreement not to make the margin requirement sky high on a whim, possibly reducing the amount of liquidity under market stress. Anyway, the phrase that comes to mind is "there are no certainties, only probabilities."

Anyway, it's not advice but rather some ways of thinking through various aspects of rates and liquidity.

0

The beauty of finance is that there's an instrument for everything. Perhaps consider PFIX?

(This is not investment advice etc.)

You must log in to answer this question.

Not the answer you're looking for? Browse other questions tagged .