In preparing for an eventual Federal Reserve rate hike and higher interest rates, fixed-income exchange traded fund investors can consider options that short bonds to hedge long debt positions.
There is a growing number of interest-rate-hedged bond ETFs for the shifting fixed-income environment ahead. For instance, the ProShares Investment Grade-Interest Rate Hedged ETF (BATS: IGHG) and the ProShares High Yield Interest Rate Hedged ETF (BATS: HYHG) are comprised of long positions in USD-denominated corporate bonds issued by U.S. and foreign companies and take short positions in U.S. Treasury notes. Additionally, the Market Vectors Treasury-Hedged High Yield Bond ETF (NYSEArca: THHY) provides another option to access high-yield, junk bonds, with a short 5-year Treasury bonds exposure to hedge against adverse movements in interest rates. [Building The Case for Hedging Interest Rate Risk: The Power of Zero Duration]
Recently, Deutsche Asset and Wealth Managment launched a group of rate-hedged bond ETFs, including the Deutsche X-trackers Investment Grade Bond – Interest Rate Hedged ETF (NYSEArca: IGIH), the Deutsche X-trackers High Yield Corporate Bond – Interest Rate Hedged ETF(NYSEArca: HYIH) and the Deutsche X-trackers Emerging Markets Bond – Interest Rate Hedged ETF (NYSEArca: EMIH). [Deutsche Bolsters Bond ETF Lineup With Three New Funds]
Additionally, for broad bond exposure, the WisdomTree Barclays U.S. Aggregate Bond Zero Duration Fund (NYSEArca: AGZD) and WisdomTree Barclays U.S. Aggregate Bond Negative Duration Fund (NYSEArca: AGND) help limit the effects of rising rates on a diverse group of fixed-income assets. [Long/Short Bond ETFs to Hedge Rate Risk, Generate Yields]
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 – bond prices have an inverse relationship to interest rates, so rising rates corresponds with falling bond prices. The short positions would essentially diminish the funds’ duration – a measure of sensitivity of the price of a fixed-income asset to changes in interest rate risks, so a a low duration would translate to a smaller sensitivity to shifting rates.
The ability to short bonds can act as a powerful hedge and return-enhancer when the credit market cracks, writes Dorothy C. Weaver, CEO of Collins Capital and former chairman of the Federal Reserve Bank of Atlanta, Miami branch, for MarketWatch.
Weaver points out that long/short credit funds can provide a buffer in a rising rate environment and even generate greater returns based on the level of exposure provided.
“It is widely anticipated that the increased volatility and dispersion will persist this year, and given current credit valuations and the upcoming Fed tightening, fixed-income investors need to take steps to cushion themselves,” Weaver said. “Therefore, we believe it can be very valuable to hold exposure to credit strategies that can invest both long and short.”
Nevertheless, potential bond ETF investors should be aware that these long/short, zero duration type strategies could underperform traditional long positions if yields begin to fall. As yields dip and Treasury prices rise, the short Treasury positions would drag on overall performance.
For more information on the fixed-income market, visit our bond ETFs category.
Max Chen contributed to this article.