The interest rate environment has been surprisingly benign in 2014. Ten-year Treasury yields have fallen nearly 12% after ending 2013 flirting with 3%.
The other side of that coin is that those yields are up 4.4% since May 27, a move that has brought some asset classes and exchange traded funds that are positively levered to rising rates back into focus. Conversely, a prolonged upside move in Treasury yields would, as it did last year, pressure scores of fixed income ETFs, many of which are among this year’s most prodigious asset gatherers. [Favorite Rising Rate ETFs Rise Again]
There are myriad ETFs with which to defend against and profit from rising rates, including hedged plays that short Treasuries while being long other bonds. That group includes the WisdomTree BofA Merrill Lynch High Yield Bond Zero Duration Fund (NasdaqGM: HYZD).
HYZD, which launched in December 2013, has a negative effective duration, an embedded income yield of 3.83% and an average yield to maturity of 4.52%, according to WisdomTree data. Over 83% of the ETF’s holdings are rated B or BB.
“With interest rates at historic lows, the values of traditional fixed income portfolios may be vulnerable to losses should rates increase in the future,” Rick Harper, WisdomTree’s Head of Currency and Fixed Income, said in a research note published earlier this year. “The WisdomTree Rising Rates ETFS allow fixed income investors to maintain traditional allocations while providing greater flexibility to manage interest rate risk.”
Negative and zero duration ETFs give investors another avenue for maintaining fixed income exposure even as interest rates rise without the vulnerability of Treasuries and, in the case of HYZD, without having to make a significant sacrifice in terms of yield.
ETFs like HYZD will short Treasuries or Treasury futures contracts to hedge against potential losses if interest rates rise. For example, HYZD currently maintains short positions in two- and five-year year Treasury futures traded on the Chicago Board of Trade. [Bond ETFs to Survive Rising Rates With]
No long position accounts for more than 4% of the ETF’s weight. Those positions include high-yield bonds from issuers such as CIT Group (NYSE: CIT), General Motors (NYSE: GM) and Sprint (NYSE: S).
“Although rates in the United States have pulled back to start the year, we believe that they will likely rise as the snow melts, resulting in a potential headwind for traditional fixed income portfolios. In our view, the zero and negative duration strategies offer another tool for investors to better insulate their portfolios against a rising rate environment,” added Harper in a March note.
WisdomTree BofA Merrill Lynch High Yield Bond Zero Duration Fund
ETF Trends editorial team contributed to this post.