My last post talked about one potential inflation hedge in the form of single family housing, which is becoming fashionable for those with significant assets. I argued that it wasn’t just the wealthy who could benefit from buying single family homes and renting them to tenants for price appreciation and inflation hedging. I explained how it was also available to smaller retail investors through single family rental REITs. As the worries about inflation linger and the Fed comes under increasing pressure to raise rate, investors will look for other avenues to hedge against a scenario of rising rates and higher inflation.

Equity Duration

There is an emerging argument that equity “duration” matters and is near an all time high in the market. Duration is a concept borrowed from the bond world. High duration bonds are longer tenor bonds which are very price sensitive to interest rates. While much of the focus of the media is on the equity market, especially when times are tough, there can be big gains in the fixed income market if you understand how to play duration. When rates fall in the short term, this can produce big moves upward in 20 and 30 year treasury bonds price wise. It’s not uncommon to see gains of 10-20% in a few months time in these bonds when events like the lockdown of March 2020 happen. This is why advisors tend to recommend a place for bonds as a part if your portfolio since there is some negative correlation with stocks: as stocks go down, bonds go up. Maybe not enough to offset the stock losses but enough so that many don’t panic and there is some built in voice back to your portfolio.

As duration relates to stocks though, some strategists and portfolio managers are starting to argue that equities in the US are showing a high level of duration meaning that higher rates could produce lower prices for shares. There is an intuitive reason for this. Growth companies have profits that are further off in the future. One theory values the price of the stock today as the discounted cash flow of future profits. That discount rate is the risk free interest rate or the rate that can be earned on short term treasuries. If that rate increases, if makes the value of the future cash flows less and hence the current value of the stock should be lower.

Since tech is an ever more important share of the S&P 500, these strategists argue that equity is now more sensitive to interest rates than it has been in the past. If equities and bonds are currently vulnerable to higher rates, then risk averse portfolios like the famous 60/40 portfolio (60% stocks and 40% equities) could suffer. Couple this fall in prices due to rates with inflation and all the sudden investors could be looking at double digit losses in real terms in the coming year for both bonds and equity (remember bond prices and interest rates move in opposite directions).

How to Play Rates

One strategist at Goldman Sachs is therefore recommending that investors take a position in writing call options on the S&P 500 as well as buying puts on the 20 year treasury index. Yet not everyone is comfortable with writing options and buying puts. Is there any alternative to dealing with higher rates affecting your portfolio?

Thanks to the proliferation of ETF’s in the past decade, there is. All types of more sophisticated strategies are available as an ETF nowadays and there are actually 2 ETF’s that can combine the above strategy to try and profit off of falling equities and bond prices at the same time due to inflation expectations and anticipation of future rate hikes.

The call write S&P 500 ETF (XYLD) is one such tool. It uses derivatives to match the performance of someone holding an S&P 500 ETF but writing calls at around the current value. Before you jump into this however, it makes sense to understand how it behaves.

Writing calls is usually performed as a strategy by index holders to generate income when the market is flat. Call options around the current price can be used for hedging or speculation by other market participants. Writing a call option limits your upside however. If the index rises above the strike price of the call option, then the writer has to deliver the underlying shares for the strike price. For this reason you will notice that there has been little change in the price of XYLD for some time or it has trended downward. The advantage it offers is that writing calls takes advantage of volatility. The greater the volatility around the current index price, the higher the price of options and hence the greater the yield of the ETF. Currently it is yielding 8.88%.

The downside of the covered call ETF is that you get some of the downside of the stock market too. When stocks plunge, like they did in March of 2020, the value of the underlying shares fall. The income from the covered call is usually not enough to make up for it, even though the payout usually increases due to more volatility. However, markets usually bounce back and this allows for a unique phenomenon with the covered call ETF: the premiums can be reinvested in the lower valued index and see some capital appreciation as well. In this sense, the covered call ETF works much like a high yield bond, another sector some strategists are recommending in the current environment.

The other downside of the covered call ETF is the taxes. The premiums from writing covered calls which are paid out monthly are taxable as ordinary income, which is one reason why the after tax return is not competitive with just holding the index in the long run. There is some research though, which points to the fact that even in down markets, the volatility hedge that the ETF and its underlying index offer, reduce the downside for investors. In addition, if stocks are down while you hold this ETF, you can sell near year end to produce a short term capital loss to offset the income it produces. This is another reason that it remains attractive as a hedge for your portfolio even in a down or flat market.

The CBOE Buy Write Index (BXM) is the one tracked by XYLD and it’s pre tax performance for the period from 1999-2014 can be seen below. This was a timeframe that saw 2 deep bear markets and yet the BXM index (on a pre-tax basis) outperformed the S&P 500. This was mostly due to the fact that the income during those volatile down markets offset the capital losses. We can also see that after 2012 when a bull market really takes hold, the S&P starts to catch up with the BXM index it underperforms in bull markets.

Short Play

The other option mention is to buy puts on the Barclays 20 Year Treasury Index. Not the same as buying puts, but an alternative is to hold the ProShares Short 20+ Year Treasury (TBF). This ETF uses derivatives to return the reverse of the price return of the 20+ Year Treasury Index.

The word of caution on this however is that it’s not a pure play on the short of the index. This ETF is designed for speculators or hedgers looking for daily use. There is some drift in performance over longer periods due to the fact that the derivative positions have to be rolled into new contracts. Even so, this offers at least the option for small investors to benefit from falling treasury prices.

Tactical Movment

A word of caution on these investing options is that they are part of a tactical approach to investing. In no way am I saying dump your portfolio for these 2 investments. A strong portfolio needs to be prepared for any type of market conditions. Over the long term, being positioned across different strategies and asset classes allow investors to reap the gains of “being there first” when they were really there the whole time.

This is a place for what are called tactical allocations to parts of your portfolio based on the economic environment and your market views. Personally, I do think that we are in for a period of slightly higher inflation which will push the Fed to raise rates next year. This could or could not produce some losses on the equity side of things but it will definitely drop the prices of bonds. When you know something like this is coming within the next year, it becomes easier to commit yourself to tactical allocations which can take advantage of this. I also have a view that the current market will trend sideways or even fall for a bit, a call writing position would benefit me were this viewpoint to turn out to be true. Time will tell.

The information provided by www.cashchronicles.com is for informational purposes only. It should not be considered legal or financial advice. You should consult with an attorney or other professional to determine what may be best for your individual needs. www.cashchronicles.com does not make any guarantee or other promise as to any results that may be obtained from using our content. No one should make any tax or investment decision without first consulting his or her own financial advisor or accountant and conducting his or her own research and due diligence. To the maximum extent permitted by law, www.cashchronicles.com disclaims any and all liability in the event any information, commentary, analysis, opinions, advice and/or recommendations prove to be inaccurate, incomplete or unreliable, or result in any investment or other losses. Content contained on or made available through the website is not intended to and does not constitute legal advice or investment advice and no attorney-client relationship is formed. Your use of the information on the website or materials linked from the Web is at your own risk.