Surprising ETF Options For Rising Rates

Yields on 10-year U.S. Treasurys are trading lower Tuesday, but a one-day pullback does not entirely erase the 52-basis point increase that occurred from June 3 through July 8.

Ten-year yields reside at just over 2.6 percent at this writing, but investors may not want too comfortable with that. On Monday, Goldman Sachs said those yields could rise to four percent by 2016.

Rising rates have prompted predictable chatter about what stocks and ETFs could be vulnerable. Telecom and utilities seem to attract the brunt of the negative attention regarding vulnerability to rising rates, but investors do have ETF options with which to endure rising rates.

In fact, some of this year's best-performing and most popular ETFs tracking a foreign market could benefit from rising U.S. interest rates. Enter the iShares MSCI Japan ETF (NYSE:EWJ) and the WisdomTree Japan Hedged Equity Fund (NYSE:DXJ). Japan and the U.S. have been developed market stars this year, but the former may not be the first destination investors think of when U.S. rates rise. Investors may want to reconsider that view.

The yield spread on U.S. and Japanese 10-years is 1.8 percentage points, versus 1.1 on average the past year, according to the Wall Street Journal. That spread and higher U.S. rates could entice Japanese investors to own more dollar-denominated assets, in turn further depressing the yen.

Well, that sounds like a theory, so what about the facts? Since June 3 when U.S. 10-year yields started rising, EWJ has jumped 7.6 percent. DXJ, which has soared to prominence because of its hedged yen component is up 5.3 percent. Importantly, those gains for EWJ and DXJ in the face of rising U.S. rates are not one-offs.

Previous 10-year yield spikes have been followed by noteworthy gains for Japanese stocks. Using historical yield data courtesy of the Treasury Department, we went searching for increases of roughly 50 basis points on U.S. 10 years in condensed time frames over the past several years and the subsequent reaction by Japanese stocks as measured by EWJ, the iShares ETF.

Going back to 2006 and including the recent June-July yield spike, we found at least seven occurrences of 10-year yields rising by at least 47 basis points in short time horizons. In five of those instances, EWJ would subsequently traded noticeably higher in the weeks and months following the yield surge.

The exceptions were a 47-basis point increase from late May through mid-June 2007 and the same increase at almost exactly the same time of year in 2008, during the financial crisis.

In 2006, 10-year yields rose 52 basis points from March 24 through May 19. From mid-June through the end of August, EWJ jumped 7.7 percent. Those adventurous enough to embrace Japanese stocks in January 2009 were rewarded. During the latter half of that month, 10-year yields surged 54 basis points. Buying EWJ at the end of the month and holding it until the end of the second -quarter resulted in a 12 percent gain.

From November 23, 2010 to December 8, 2010, yields climbed 49 basis points. Buying EWJ a couple of days later and holding it through the end of February resulted in an almost nine percent gain. A similar scenario was seen in September/October 2011 when yields rose 52 basis points. Holding EWJ through the end of the first quarter of 2012 resulted in a seven percent reward.

Remember, EWJ was used as the proxy here and that ETF does not offer a USD/JPY hedge as do DXJ and the newly minted WisdomTree Japan Hedged SmallCap Equity Fund (NYSE: DXJS). DXJ was recently rebalanced and now has slightly higher weights to Japanese discretionary and industrial names, perhaps giving the ETF more leverage to the rising U.S. rates/falling yen story.

"Within every sector, the revenue filter applied to determine constituent eligibility led to lower weighted average revenues being generated from inside Japan, thereby indicating that its constituents are more globally focused in their revenue base," said WisdomTree Research Director Jeremy Schwartz in a new research note.

For those that are in need of a catalyst beyond rising U.S. interest rates as a reason to embrace Japan ETFs consider the following: Japan holds elections for control of its upper house of parliament in less than two weeks. It is widely expected that Prime Minister Shinzo Abe's Liberal Democratic Party will gain control of the upper house, potentially giving Abe room to further depress the yen while initiating new reforms aimed at bolstering Japan's domestic recovery.

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