More Bond Investors Bet on US Rate Rise

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More U.S. bond investors are seeking new ways to hedge against the risk of a sharp rise in interest rates in case growth in the world's largest economy picks up and the Federal Reserve starts to wind up its current stimulus policies.

The U.S. central bank is expected on Wednesday to maintain its current level of bond purchases, which have pushed up bond prices and kept rates low. However, some investors are taking positions in exchange traded funds and leveraged loans that are designed to profit if market interest rates spike higher.

More money has flowed into leveraged loan mutual funds in the first 10 weeks of this year than in the whole of 2012, according to the latest data from Lipper. Loans have floating interest rates and can be used as a hedge against sharply rising rates.

Inflows into junk bonds, which pay a fixed rate of interest and whose value will therefore fall when market rates rise, have proved more volatile after their strong performance last year.

Lipper said $12.4 billion has flowed into leveraged loan mutual funds so far this year, compared with a total of $11.9 billion for all of 2012.

Carl Eichstaedt, a senior portfolio manager for Western Asset Management, said that he now prefers bank loans to junk bonds. "Because short term rates have been so low for so long, bank loans have been the step child of high yield," he said.

Mr Eichstaedt also said that due to the policies of the Federal Reserve "short term rates will stay lower than they otherwise should, given the cyclical recovery, but five to 10 year rates could go higher." He said that he was not expecting an immediate move, "but we don't want to be the last one left at the party."

As well as loans, some investors have also sought out rare floating rate bonds. Earlier this month, General Electric issued $500 million in floating rate debt that matures in 10 years, the first such issue this year. Only about $5 billion of such notes have been sold since 2008, according to Dealogic.

Meanwhile, a record volume of bets has been laid against the value of the two largest junk bond ETFs. There has been a 50 percent increase in the level of so-called short interest in the iShares iBoxx High Yield Corporate Bond ETF in the past month, according to IndexUniverse.

And speculators have borrowed a record 26.34 million shares in the SPDR Barclays Capital High Yield Bond ETF, the equivalent of 4.85 days' trading. When traders short such a security, they sell borrowed shares, hoping to return the equivalent to the lender later after buying them more cheaply.

Edward Marrinan, head of macro credit strategy at RBS, said short selling ETFs is a less expensive, and less than permanent, way to bet on rising rates and falling bond prices.

"It takes a long time to build a bond portfolio," he said. "You don't want to dismantle your portfolio, given you killed yourself to build it, so what you do is use a lower-cost, more liquid instrument to hedge it."

Michael Kastner, a principal at Halyard Asset Management, said U.S. Treasury yields look vulnerable if economic data surprises positively.

"Traders and real money investors are looking to lessen their interest rate sensitivity, and are looking at floating rate notes and short dated bonds," he said.

Michael Hasenstab, who oversees $170 billion in global fixed income investments for Franklin Templeton, said: "I fear most people are not well positioned for higher rates."

He said that the conventional wisdom has been that a bond fund tracking a broad index is considered low risk, but "while this may have worked to dampen risk in the last decade, it is unlikely to work in the next when interest rates rise".