SM: Are Short-Term Yields Calling...

In an effort to boost the economy, the Federal Reserve announced in January it would maintain short-term interest rates at exceptionally low levels through at least late 2014, more than a year longer than had been previously stated.

Yet in recent weeks, it's almost as if someone forgot to tell the debt securities most influenced by the Fed itself.

Since the Fed's announcement on Jan. 25, the yield on the 2 year Treasury notes, the short-term government obligations most impacted by interest-rate policy have actually risen. This past week, it jumped from 0.20% to 0.31% -- the highest since late October. It's almost as if the free market is calling the Fed's bluff.

When The Fed Speaks, Does the Market Listen?

Bloomberg

US Government 2-year yield 1 month

That's helped shares of iPath US Treasury 2-Year Bear ETN (DTUS), the thinly traded exchange-traded note we wrote about late last year as one of the few options for everyday investors to bet against short-term bonds. The unlevered notes provide exposure to an increase (or decrease) in 2-year Treasury yields, less expenses.

Whether it's concerns over inflation, credit risk or simply supply and demand, short-term bond yields are near multi-month highs, yet still significantly lower than just a few years ago. At a recent 0.30%, the two-year yield is up from all-time-lows yet still nowhere near the 5% it traded at as recently as 2007.

In addition to betting against shorter-term bonds, an alternative or additional strategy might be to invest in a basket of those which could potentially benefit if rates do rise.

Floating rate funds, often called bank-loan funds, hold short-term corporate bonds whose coupons "float," or adjust with changes in short-term rates, making them among the few income instruments that can do well in periods of rising rates. Think of it as owning someone else's adjustable rate mortgage instead of paying one yourself.

This niche area of the capital markets has undergone tremendous growth since we first wrote about the asset class back almost a decade ago, helped partly by the recent introduction of a trio of exchange-traded-funds -- Market Vectors Investment Grade Floating Rate (FLTR), SPDR Barclays Capital Investment Grade Floating Rate (FLRN) and iShares Floating Rate Fund (FLOT), which, at $64 million and 13,000 average volume, is by far the most liquid option.

The closed-end funds like ING Prime Rate Trust (PPR), Invesco Van Kampen Senior Income (VVR) and Eaton Vance Floating Rate Income (EFT) which previously dominated the sector tended to trade at wide premiums and discounts to their net-asset-values. The ETF format virtually eliminates that risk.

If defaults skyrocket, as was the case in 2008 and 2009, or rates again turn lower, the funds could underperform. But if current trends on the short end of the yield curve persist, the optimum trade might not be waiting for higher rates, but betting on them before they actually return.

Jonathan Hoenig is managing member at Capitalistpig Hedge Fund LLC. At the time of writing, Hoenig's fund held positions in many of the securities mentioned.