Two funds to profit from rising yields

The approval of the first coronavirus vaccine last November changed the investment landscape, with rising inflation expectations pushing ten-year US Treasury yields substantially higher. 

Central banks have been using quantitative easing to anchor short-term government bond yields and increase the money supply for years, but the addition of substantial fiscal stimulus just as economies are re-opening could finally see the return of inflation. 

The Federal Reserve has been at pains to point out that any increase would only be transitory and that they are ‘not even thinking about thinking about raising interest rates’, yet the market doesn’t seem to believe them. 

Over the last 12 months the ten-year US Treasury yield has risen from 0.62% to 1.72%, which is a massive move for the bond market. Normally, the yield would be well in excess of inflation to compensate for the loss of purchasing power, but the ten-year breakeven inflation rate has gone from 1.14% to 2.35%, so yields could still go substantially higher. 

Short bond ETF

The most direct way to benefit from higher yields would be to invest in a product like the Lyxor UCITS ETF Daily Double Short 10Y US Treasury (LON:DSUS), which is available on the London Stock Exchange and priced in US dollars. 

It is designed to make money when the US ten-year Treasury yields rise, but the ‘daily double short’ aspect makes the cumulative performance hard to reconcile to the underlying market. For example, although the ten-year yields have risen from 0.62% to 1.72% in the last year, the ETF is only up 7.7% over the same period.  

The reason it is worth considering is as portfolio protection in the event of a sharp increase in yields following an inflation surprise to the upside. This could prompt fears of an earlier than expected increase in interest rates that could choke off the economic recovery and result in a sharp sell-off across many different asset classes. 

Banking stocks ETF

If you think that long yields will rise steadily – rather than calamitously quickly − as the economy improves then there are lots of more profitable options including the Ishares S&P  US Banks UCITS ETF (LON:BNKS), which provides exposure to the banking sector of the S&P 500 index. 

The bank stocks that it invests in benefit from a steepening of the yield curve as they essentially borrow short-term and lend long-term. Over the last 12 months, the ten-year US Treasury yield minus the three-month yield has risen from 0.52% to 1.70% and this has helped BNKS to gain 106% during the same period. 

Higher yields represent both an opportunity and a risk depending on how far and how fast they move, but they could also decline, which would be bad for both of these funds. If inflation doesn’t materialise or there is some kind of black swan even like Chinese military action against Taiwan, then investors might come back in and bid up US Treasury prices, thereby forcing the yields lower.