The Silver Lining in Rising Interest Rates

Much has been made about the artificially low-interest rate environment formed by central banks and their quantitative easing punishing savers – with one effect being investors moving into riskier assets in a reach for yield. But with the US 10 Yr Note going over 3% for the first time since 2014, the conversation is starting to turn from how low rates were bad, to how high rates are bad. The arguments surround the usual topics, such as the Fed won’t be able to catch up with inflation, longer duration bond investors will see marked to market losses (as rates rise, prices fall), and the credit markets may tighten up.  But surely if low rates were bad for groups such as savers… then higher rates must be good for some groups…. No?

Enter Ben Carlson of the Wealth of Common Sense blog with his latest post “Who Benefits from Rising Interest Rates, ” in which he nails one particular nail on the head we happen to know a thing or two about.

CTAs who invest using a trend-following approach could also benefit from higher short-term interest rates. These funds trade mostly futures and hold 80 percent to 90 percent of their assets in cash as collateral for those futures contracts.

These funds were helped by high interest rates in the 1980s and 1990s but have been penalized by lower rates in recent years….But higher interest rates could provide a tailwind for this [space].

What’s all that mean – CTAs, cash as collateral, and so forth? Well, CTAs are a professional investment manager category where asset managers are registered as Commodity Trading Advisors. These advisors are generally lumped together under the moniker managed futures, and specialize in trading exchange-traded futures contracts both long and short in markets across the world. Futures contracts, as you may or may not know, have naturally built-in leverage – where you only have to put up $750 in an account, for example, to control $20,000 worth of Corn. What this means at the professional level of managing money using futures contracts, is that you can get, say, $750 million worth of managed futures exposure, by putting up just $250,000 of cash into the trading account.

What to do with that extra $500 million? Well, you can leave it on deposit with the clearing firm and purchase some T-Bills to earn interest, or you can hold it back in your main accounts and buy bonds with it! Now, you probably don’t want to get too carried away buying the bonds and turn the managed futures product into more of a bond product. But why not earn as much interest as you can on short-dated maturities which aren’t likely to skew the portfolio towards a bond profile. That has typically been accomplished with short-dated treasuries, but managed futures funds (especially in the mutual fund wrapper) have been going further afield into corporates and floating rate notes and the like. Just take a look at what we found under the hood for one of the larger managed futures mutual funds (those aren’t your father’s T-Bills):

Interest Rate Managed Futures Mutual Fund

Problem is – there hasn’t been much money to be made on the extra money for much of the past 10 years, with 1-year yields on Treasuries below 1% until earlier last year (and below 0.50% for a big portion of that). But change is afoot,  with 1-year T-Bill constant maturity rates now up at 2.2% and other interest rate products are following suit in a big flattening of the yield curve (short term rates rising faster than long term rates). So, while a classic trend follower may look at the chart below and see a good trade, sophisticated investors understand that there are actually TWO trades going on for managed futures in a rising interest rate environment. One, the ability to go short bond prices (rates up) to capture profits from any extended trend in that direction. And two, the ability to earn a higher interest rate “on the side,” so to speak, via investments in T-Bills, bonds, and other notes with their excess cash.

1 Year T Bill Maturity Rate(Disclaimer: Past performance is not necessarily indicative of future results)

 

Disclaimer
The performance data displayed herein is compiled from various sources, including BarclayHedge, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.

Benchmark index performance is for the constituents of that index only, and does not represent the entire universe of possible investments within that asset class. And further, that there can be limitations and biases to indices such as survivorship, self reporting, and instant history.

Managed futures accounts can subject to substantial charges for management and advisory fees. The numbers within this website include all such fees, but it may be necessary for those accounts that are subject to these charges to make substantial trading profits in the future to avoid depletion or exhaustion of their assets.

Investors interested in investing with a managed futures program (excepting those programs which are offered exclusively to qualified eligible persons as that term is defined by CFTC regulation 4.7) will be required to receive and sign off on a disclosure document in compliance with certain CFT rules The disclosure documents contains a complete description of the principal risk factors and each fee to be charged to your account by the CTA, as well as the composite performance of accounts under the CTA's management over at least the most recent five years. Investor interested in investing in any of the programs on this website are urged to carefully read these disclosure documents, including, but not limited to the performance information, before investing in any such programs.

Those investors who are qualified eligible persons as that term is defined by CFTC regulation 4.7 and interested in investing in a program exempt from having to provide a disclosure document and considered by the regulations to be sophisticated enough to understand the risks and be able to interpret the accuracy and completeness of any performance information on their own.

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