Rising interest rates generate negative returns for bond funds. To match higher yields, bond prices have to fall. In a higher-for-longer interest rate world, investors need alternatives to traditional bond funds.
Today, let’s look at a bond fund using an alternate strategy that has generated excellent returns over the last three years.
I recently learned about a bond fund that has performed tremendously well over the same time period. Launched on September 30, 2021, the FolioBeyond Alternative Income and Interest Rate Hedge ETF (RISR) has posted a total return of 62.04% since its IPO, which works out to an annual return of 19.2%. RISR has a current dividend yield of 7.1%.
RISR accomplished this record with an agency mortgage-backed securities interest-only (MBS IO) instruments portfolio. These MBS IOs have a negative duration, which means that security prices will increase as interest rates rise.
Duration is a metric that indicates how much a bond portfolio’s value will change with a change in interest rates. Positive duration means that values will fall as rates increase. TLT has a duration of 16.5 years. In contrast, RISR has an effective duration of negative 5.0 years.
In practice, MBS IO prices are positively correlated to 10-year Treasury yields. They also offer a positive carry of 7% to 8%, which accounts for the RISR dividend yield.
The question now is what happens with RISR when the Fed starts to cut interest rates.
There are a couple of factors in play. The Fed controls rates at the short end of the yield curve, while market forces set longer-term rates. As the Fed increased rates over the last two-plus years, the yield curve turned negative, with short-term rates significantly higher than long-term rates. The normal rate structure has a positive slope to the yield curve.
The current yield curve structure means that even as the Fed cuts rates on the short end, longer-term rates will likely not fall, returning the yield curve to a positive slope. Also in the mix is the massive amount of federal debt, which could lead the market to demand more yield to continue to fund the debt.
The bottom line is that RISR should remain an effective investment for the fixed-income portion of your portfolio. Pairing it with a traditional bond fund may make sense to have an income-paying hedge against changes in interest rates in either direction.
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