Many investors find bonds to be puzzling, at least at first. Fortunately, a lot of bond “complexity” can be boiled down to this simple rule: Bond prices always move opposite to bond yields. This means that when yields (i.e., interest rates) are rising, bond prices fall — and vice versa.

As this month’s Editorial explains, expectations for future economic growth (along with potentially higher inflation) began rising following the positive vaccine news in November and the election results. Longer-term interest rates began moving higher immediately. The 10-year Treasury yield, for example, rose from 0.78% in November 2020 to 1.50% by the end of February 2021. That significant jump in a little over three months understandably has investors wondering how high will rates go?

How bond investors typically protect against rising rates

If the first rule of bond investing is that “bond prices and yields always move in opposite directions,” then the second rule is “the longer until the bond matures, the more its price will move in response to changes in interest rates.” Given that, the way bond investors typically protect themselves from rising rates is to shorten the maturities, or duration, of the bonds they own. (That’s a significant driver of the change being made this month in Bond Upgrading.) Of course, this means accepting the lower yields provided by shorter-maturity bonds.

However, other tools can help deal with rising interest rates too. Investing in individual bonds, for example, can provide a degree of protection against rising interest rates. And SMI has written before about TIPS, a specific type of bond (included in our Bond Upgrading universe) that offers protection against rising inflation, though not necessarily against rising interest rates generally. In other words, TIPS will normally perform better than other bonds during periods of rising inflation, but can still lose value due to rising rates, because rising rates aren’t exclusively caused by higher inflation.

Introducing IVOL – a better defender

Unlike the options just discussed, which focus on either losing less than other types of bonds or settling for today’s paltry yields, there is a relatively new product that stands to benefit from rising interest rates. Indeed, the “Quadratic Interest Rate Volatility and Inflation Hedge ETF” (ticker: IVOL) is designed to excel in the interest rate environment we have today.

The bulk of IVOL’s portfolio is invested in TIPS, providing it with a high degree of protection against rising inflation expectations. But IVOL adds another layer of protection against rising interest rates that distinguishes it from pure TIPS funds.

In today’s environment, in which the Federal Reserve has short-term rates pinned near zero and has repeatedly stated that it intends to keep those rates low for an extended period of time, this effectively means that any increases in longer-term interest rates widens the “spread” between the two rates. This is exactly what has been happening in recent months: longer-term rates have risen rapidly, while short-term rates have barely budged. What IVOL protects against is this widening spread between short- and long-term interest rates. It does this by purchasing call options that rise in value when the rate spread widens.

It’s important to note that IVOL is less than two years old. It began trading in May 2019, so we can’t look back at past periods of extreme interest rate activity to see how it performed. Its risk appears to be limited, however. The options it purchases have unlimited upside as the spread between short-long interest rates widens. But if that spread narrows instead (as would be likely if rates reversed and started falling), IVOL’s risk is limited to the premiums paid for the options. Of course, falling interest rates normally would benefit the TIPS portion of the portfolio, helping offset any negative impact from the options portion of the portfolio.

How to utilize IVOL

The easiest way to think about IVOL is to consider it a diversifier that tends to respond to interest-rate changes in a manner that is opposite of a traditional bond portfolio. Most bonds gain in value when interest rates are falling (which often, though not always, corresponds with periods of distress for other financial assets, such as stocks). In contrast, IVOL normally will gain in value when rates are rising, as long as longer-term rates increase faster than shorter-term rates.

Investors with large stock allocations probably don’t need much IVOL exposure, because stocks tend to perform well in the same type of environment in which IVOL excels. But if you have a bond-heavy portfolio, IVOL can be a great diversifier, offering significant upside during conditions that usually produce poor returns for a conventional bond portfolio. Better yet, IVOL offers that upside without the massive downside risk that stocks bring to a portfolio.

Last year’s bear market is a great example. Between February 19-March 23, the S&P 500 stock index lost over one-third of its value. Even the conservative anchor of SMI’s Bond Upgrading strategy, the Vanguard Short-Term Bond Index (BSV) fell slightly, losing -0.1%. IVOL gained +0.3% during that period and, more importantly, has gone on to gain +18.4% since then. In contrast, BSV is up only +3.8% (March 24, 2020-February 17, 2021).

Caveats and final thoughts

After significant deliberation, SMI has decided not to add IVOL to the newsletter’s Bond Upgrading portfolio at this time. While its short track record is one factor, the primary reason we’re not is that IVOL doesn’t fulfill the normal role of diversifying a portfolio against stock market risk. That’s specifically what many SMI members rely on Bond Upgrading to do within their portfolio. So rather than include IVOL in every Bond Upgrading portfolio, we’re explaining it so that each individual SMI member can decide if it makes sense in light of their specific situation.

Allocating a portion of a portfolio to IVOL will likely be most appealing to those with large allocations to traditional bonds. On the other hand, those with small bond allocations may find including IVOL takes away from the stock market diversification role they expect from their bonds.

(Full disclosure: SMI Advisory Services will use IVOL within its Private Client portfolios. SMI Advisory is are able to respond more quickly to trend changes in interest rates and their setup allows the suitability of the product to be matched more closely to each specific client.)

For those who want to include IVOL in their portfolio, it’s an easy thing to add. Simply take a portion (perhaps 25-50%) of the proceeds from this month’s Bond Upgrading sale and invest it in IVOL rather than rolling the full proceeds to the new fund recommendation.

While interest rates have been rising rapidly in recent months, there’s no guarantee that trend will continue. Any type of economic or stock market shock could break the upward momentum in interest rates, which would likely stop IVOL’s positive momentum as well. Most investors need their bonds to fulfill the shock absorber role within their portfolio, so don’t go overboard replacing all of your traditional bonds with IVOL.

But the Quadratic Interest Rate Volatility and Inflation Hedge ETF can certainly play a useful role in helping bond investors diversify against the risks of rising interest rates and increasing inflation expectations. With government policy pointed in a direction that could send interest rates much higher over an extended period, IVOL could be quite a useful tool for bond investors in coming years.