Rate-Hedged Bond ETFs Outperform as U.S. Yields Soar to 2016 High

With investors anticipating a large fiscal stimulus that President-elect Donald Trump pledged to enact, yields on Treasury yields surged to their highest levels this year, but exchange traded fund investors who utilized interest-rate hedged strategies hardly noticed the rout in the bond market.

For instance, the popular investment-grade corporate bond ETF, iShares iBoxx $ Investment Grade Corporate Bond ETF (NYESArca: LQD), fell 2.3% over the past week while the iShares Interest Rate Hedged Corporate Bond ETF (NYSEArca: LQDH) rose 0.3%, Deutsche X-trackers Investment Grade Bond – Interest Rate Hedged ETF (NYSEArca: IGIH) increased 1.4% and the ProShares Investment Grade-Interest Rate Hedged ETF (BATS: IGHG) returned 1.0%.

While the popular iShares iBoxx $ High Yield Corporate Bond ETF (NYSEArca: HYG) fell 1.8% over the past week, the iShares Interest Rate Hedged High Yield Bond ETF (NYSEArca: HYGH) showed a smaller drawdown of 1.1%. Moreover, the Market Vectors Treasury-Hedged High Yield Bond ETF (NYSEArca: THHY) gained 0.8%, ProShares High Yield Interest Rate Hedged ETF (BATS: HYHG) increased 0.3% and WisdomTree BofA Merrill Lynch High Yield Bond Zero Duration Fund (NYSEArca: HYZD) was down 0.4% over the past week.

These interest-rate hedged bond ETFs hold short positions in interest rate swaps, which more or less provide the rate-hedged ETF a 0 effective duration – duration is a measure of a bond fund’s sensitivity to changes in interest rates so a zero duration reflects no sensitivity to changes.

The strategy should help an interest-rate-hedged ETF outperform its non-hedged options if rates continue to rise. The rate-hedged strategy has outperformed after yields on benchmark 10-year Treasuries surged to 2.22% Monday from 1.78% prior to the election.

Yields on 10-year notes touched 2.3% Monday, the highest intraday level since December, marking a quick reversal from just fourth months aga when it touched a record-low of 1.318%, Bloomberg reports.

The recent jump in yields was attributed to growing bets of a Federal Reserve interest rate hike to obviate a potentially overheating economy as a result to potential fiscal stimulus under a Trump administration.

“We are reaching a paradigm shift in the bond market,” Matt Eagan, a money manager at Loomis Sayles, told Bloomberg. “Trump’s policies, at least taking them at face value right now, are inflationary at a time when the slack in the economy is actually tightening and we have very aggressive monetary policy.”

Looking at fed funds futures, options traders are betting on a 92% chance the Fed could hike interest rates in December. More anticipate further tightening in the year ahead.

The rise in yields “can continue — we are still at low rate levels,” Priya Misra, head of global rates strategy at TD Securities (USA) LLC, one of 23 primary dealers that trade with the Fed, told Bloomberg. “Another 25 to 50 basis points on the 10-year is possible.”

For more information on the fixed-income market, visit our bond ETFs category.

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