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ETF interest rate strategies


Exchange traded funds provide a great way to trade economically sensitive interest rates

Few products are as expensive and complex as interest rate futures. For retail traders looking for interest rate exposure, Treasury ETFs are a much better place to start.

But before you buy a bond ETF, take the time to understand some basics about rates. Before buying a Treasury ETF, it is important to understand some basics about rates. First, know that there is no single interest rate. Interest rates are determined by a number of factors, one of which is how likely a borrower is to repay the money. The greater the risk of default, the higher the interest rate. This is referred to as credit risk. Use Treasury ETFs to avoid credit risk and only trade rates. Backed by the robust US economy, treasury debt is largely considered “risk-free” with no credit risk and serves as a global benchmark for interest rates. To trade rates and avoid credit risk, look at trading U.S. Treasury yields because U.S. government debt is largely considered “risk-free” because of its high credit quality.

Originally published in Luckbox Magazine. Sign up for free at getluckbox.com/techlives

A second factor that determines the interest rate is the length of the loan. Treasury debt is auctioned with expiration dates ranging from 30 days to 30 years, and each has its own interest rate. By plotting each of these rates and their respective durations, it creates the yield curve. (See “Yield Curve,” below.)

Note that the longer the duration of the loan, the greater the interest rate. When choosing which rate to trade, remember that longer-dated debt also has greater volatility. Several popular Treasury debt ETFs and their weekly one-standard deviation series are shown in the chart. The further up the curve an investor trades, the greater the weekly movement.

While these ETFs offer a great way to trade rates, note that they represent a basket of Treasury debt prices and not their returns. Debt prices and debt yields are reversing. So, a trader who thinks 20+ years of interest rates will fall can buy, and one who thinks they will rise may sell. An increase in debt prices is always associated with a decrease in yields and vice versa. While price is an equalizer to compare bonds, traders live in a world of returns. Thus, an inversion is often required to go from trading idea to trading execution.

In addition to trading a specific portion of the yield curve, advanced interest rate trading strategies can also be put together using these ETFs. A trader can combine this to trade kinks and shifts in specific sections of the yield curve. Instead of buying or selling 20+ year rates, a trader can buy iShares 1-3 Year Treasury Bond ETF (SHY) and sell iShares Barclays 20+ Year Treasury Bond ETF (TLT) simultaneously for a yield curve- build trade that makes a profit if the difference between short-term and long-term rates rises. This is referred to as a steepening of the yield curve. With products covering all parts of the yield curve, traders can trade almost all expectations of economic change with interest rates. (See “The Right Shares,” below.)

ETF interest rate strategies

Michael Gough enjoys retailing and writing code. He works in business and product development at the Kleinbeurs, and builds index-based futures contracts and professional partnerships.

Originally published in Luckbox Magazine. Sign up for free at getluckbox.com/techlives

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