Hedging Rate Risks with Bond ETFs

August 5th at 4:45pm by Tom Lydon

As interest rates inch up, bond exchange traded fund investors have to find a delicate balance between rate risk and portfolio diversification.

After yields on benchmark 10-year Treasuries rose a full percentage point to 2.7% from May to July, long-maturity bond funds tracked by Morningstar declined 7.5%, even with interest income, reports Michael A. Pollock for the Wall Street Journal. Yields on 10-year Treasuries currently sit around 2.65%. [iShares: ETF Mythbusting — Price Matters for Bond Investors]

Bond prices and yields have an inverse relationship. In a rising rate environment, bond funds, especially those with longer maturities, will experience declines. Consequently, investors pulled $81 billion out of fixed-income mutual funds and ETFs in June.

Nevertheless, some have argued that the recent spike in interest rates was overdone, considering the sluggish economic expansion, high unemployment rate and low inflation. When the Fed does decide to taper its bond purchasing plan next year, observers anticipate rates to rise to 3.5% or 4%. Morgan Stanley, though, maintains that rates will remain between 2% to 2.75% this year.

When considering rate risk on a fixed-income portfolio, ETF investors have to look at the duration. The higher the duration, the greater the interest-rate sensitivity or potential drop in value if rates rise. Typically, a fund’s duration corresponds with the percent decline if interest rates rise 1%. For instance, a fund with a two-year duration would see a 2% price decline if interest rates increased by 1%.

A few fixed-income assets will also see their rate-sensitivity rise along as yields increase. For example, the maturities on mortgage bonds have risen to an average 5.2 years from 3.7 years this spring. Meanwhile, the rate on long-maturity 22-year to 30-year municipal bonds rose to 14 from 11.

Next page: Bond ETFs for rising rates

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