This strategy is based on shorting a Treasury index or a basket of Treasuries. While this type of exposure avoids spread risk, the negative carry can become expensive depending on the holding period. A levered exposure through the use of options may create a better payout profile, but at the expense of even higher carrying costs while waiting for rates to rise.
Floating Rate Strategy
A floating rate strategy involves the use of floating rate instruments to create a flat to slightly negative duration profile. As short term rates (typically LIBOR) rise, the coupon is reset to the higher index level, boosting current income. There are two caveats to this strategy, however. First, floaters will provide a modest form of income protection only if short term rates rise. If the intermediate and the long duration sectors of the Treasury yield curve rise in anticipation of planned Fed rate hikes or inflationary concerns, this strategy will not provide any immediate benefits. The second major risk is spread duration risk. While interest rate duration is neutral, most floaters have longer spread durations. A 5-year, non-amortizing floater would typically have spread duration of over 4 years. Therefore, in a rising rate environment accompanied by widening spreads, the price decline can more than offset any increases in coupon income.
MBS IO Strategy
This strategy involves the use of Interest Only (IO) instruments off agency mortgage backed securities (MBS). While this may appear complex for investors not familiar with MBS products, this strategy has many appealing characteristics if implemented the right way. First, MBS IOs have negative durations to start with due to the inverse relationship between interest rates and prepayments. As interest rates go up, prepayment rates tend to decline, increasing the value of MBS IOs. The correlation of IO valuations to Treasury movements has been very high historically. Secondly, with the right mix of coupons and pools originated in certain years, the portfolio can be constructed to have positive projected base case yields even if rates remain stable. Additionally, an attractive asymmetric profile can be set up by focusing on the right premium coupons that have greater upside in value (downside in prepayments) relative to their downside. With respect to spread risk, MBS IOs will be subject to spread widening along with all other spread products. However, a mitigating factor is that spread widening of MBS bonds should have a dampening effect on prepayments (due to higher current coupon mortgage rates) which by itself would increase MBS IO valuations, thereby offsetting the direct impact of wider MBS IO spreads. One hurdle in implementing this strategy for some investors is complexity and product expertise.
This article was written by Treesdale Partners, portfolio manager of the AdvisorShares Gartman Gold/Euro ETF (GEUR), AdvisorShares Gartman Gold/British Pound ETF (GGBP), AdvisorShares Gartman Gold/Yen ETF (GYEN) and AdvisorShares International Gold ETF (GLDE).