After a three-decade rally in the fixed-income market, bond investors will likely have to contend with a rising rate environment ahead. Nevertheless, people can utilize exchange traded funds that leverage institutional approaches to manage their risk exposure.
“While we don’t anticipate that rates will soar, we are concerned over the long term of the vulnerability of bond returns to a moderate rise in rates,” Rick Harper, WisdomTree’s Head of Fixed Income & Currency, said on the recent webcast, Fixed Income Strategies at Taper’s End – Are You Really Prepared?
Investors are may be overexposed to interest rate risk. Ideally, fixed-income investors should have a balanced duration and yield exposure. However, due to the low rate environment, investors have been forced into longer durations to generate more attractive yields. Consequently, a small bump in interest rates could wipe out a large chunk of income gains.
“Relative to historical periods, U.S. bonds are offering limited coupon cushion with greater sensitivity to interest rates,” Harper said.
For example, on a recent ETF Trends survey, most financial advisors believe the Fed will begin hiking rates sometime in the second half of next year.
Investors, though, have been moving down the yield curve to hedge against rate risk. For instance, the so-called taper tantrum provided a test run for rising rates, but short-duration bonds only helped preserve capital with mediocre gains. [Short-Term Bond ETFs: Cool Kids at the Fixed Income Party]
“While these strategies performed well during the Taper Tantrum, we would argue that investors might be disappointed when the limited income of such strategies could be tested when short rates start to rise,” Harper added.
Alternatively, investors can use fixed-income ETF strategies that mimic institutional hedging styles to manage risk.
For instance, the WisdomTree Barclays U.S. Aggregate Bond Zero Duration Fund (NYSEArca: AGZD), WisdomTree Barclays U.S. Aggregate Bond Negative Duration Fund (NYSEArca: AGND), WisdomTree BofA Merrill Lynch High Yield Bond Zero Duration Fund (NYSEArca: HYZD) and WisdomTree BofA Merrill Lynch High Yield Bond Negative Duration Fund (NYSEArca: HYND) all try to diminish the risk of a rising rate environment without moving down to shorter durations by simply just hedging the interest rate risk instead.
Specifically, these new types of zero duration or negative duration ETFs hold long-term bonds, but they will short Treasuries or Treasury futures contracts to hedge against potential losses if interest rates rise. Moreover, the negative duration ETFs try to profit off a rising rate environment by heavily using short contracts to capitalize on falling bond prices if rates do rise. However, due to the more aggressive nature of this strategy, these types of ETFs will underperform if rates fall.
Additionally, these hedged bond ETFs help preserve some income generation. AGZD has a 0.12 year effective duration and a 1.44% 30-day SEC yield. AGND has a -5.02 year duration and a 1.38% 30-day SEC yield. HYZD has a -0.34 year duration and a 4.23% 30-day SEC yield. Lastly, HYND has a -7.44 year duration and a 4.32% 30-day SEC yield.
Financial advisors who are interested in learning more about bond strategies for the changing fixed-income environment can listen to the webcast here on demand.