How to Cash In on Rising Rates

For years, the bull market in bonds has produced solid returns for bond investors. Despite seemingly ever-present threats of higher interest rates, the repeated calls from bond bears have made the boy who cried wolf seem like an optimist.

But in recent days, the bond market has seen one of its steepest sell-offs in a long time. So if you're considering once more going into the breach, it pays to know the best ways to profit if this is indeed the beginning of a longer-term move up in interest rates.

Easy to buy, hard to short
The most obvious way to bet against bonds would be to sell them short. But it's hard enough to figure out how to buy bonds when you visit most online brokers, and there's no mechanism for selling bonds short that individual investors can take advantage of in the same easy way shorting stocks works.

So if directly selling bonds short won't work, the next logical alternative is to use exchange-traded funds that own bonds. Selling short the iShares Barclays 20+ Year Treasury ETF (NYS: TLT) , for instance, would amount to the same trade as shorting Treasury bonds themselves.

The mechanism for shorting ETFs is similar to shorting stocks, and most online brokers will let you do it. The challenge here, though, is finding shares to borrow. Remember that to sell shares short, you first have to find someone willing to lend you those shares. For ETFs that are in high demand from short-sellers, it can be nearly impossible to locate shares to sell short -- and if you do, the financing charges you pay could well eat up any potential profits.

Turning to the dark side
It's for this reason that many investors resort to inverse ETFs. For instance, the ProShares UltraShort 20+ Year Treasury ETF (NYS: TBT) gives you daily returns of twice the opposite of the iShares 20+ Year ETF. So if prices of the iShares Treasury ETF go down 1% in a given day, the ProShares ETF is designed to rise by 2%.

For short-term trading, that can be a very effective strategy. But over time, leveraged bond ETFs suffer from the same phenomenon as their stock-focused counterparts: slippage. Because they're designed to target daily returns, leveraged ETFs don't always behave the way you'd expect over the long run. If bonds lose value in a volatile way, you could easy see the ProShares ETF lose money, rather than providing great returns.

Going with rate-sensitive stocks
Sometimes the best way to play a trend is to look beyond its victims to identify stocks that will benefit from it. With rising bond yields, the winners depend on which rates go up.

If the Fed keeps short-term rates at rock-bottom levels but allows long-term rates to rise, then expect banks to benefit, with Citigroup (NYS: C) and Bank of America (NYS: BAC) potentially among the biggest winners. Citi has seen interest expense fall by two-thirds since 2007, but interest income has also plunged. If long rates rise, that income could jump without a corresponding bump in interest expense, creating more net interest income. B of A hasn't seen such dramatic moves, but the potential for additional profits is still substantial.

On the other hand, if short-term rates also rise with long-term ones, banks won't necessarily win out. But companies that have huge amounts of cash on their balance sheets will. With Apple's explosive growth, a few extra percent of cash won't make a huge difference. But for slower-growing cash-rich companies, it could. Microsoft (NAS: MSFT) , for instance, has more than $50 billion in cash and short-term investments. An extra two percentage points on that cash would generate $1 billion more in interest per year -- boosting net income by between 4% and 5%.

Be smart
Bond yields have done numerous head-fakes during the bull market in bonds, and there's no guarantee this won't be another one. But if you think this time is different and that now's the time to make money on rising bond yields, using some of these strategies could be the right idea.

Don't forget, though: Investing only in bonds won't get you to your financial goals. For some interesting stocks that could help you diversify your portfolio, be sure to check out the Motley Fool's latest special report on retirement. Inside, you'll find three promising stock picks for long-term investors. It won't cost you a thing, but don't wait; get your free report today while it's still available.

At the time thisarticle was published Fool contributor Dan Caplinger has been a bond bear far too long. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Apple, Bank of America, Microsoft, and Citigroup. Motley Fool newsletter services have recommended buying shares of and creating bull call spread positions on Microsoft and Apple, as well as writing puts on ProShares UltraShort 20+ Year Treasury. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy always rises.

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