First, some quick ground rules. This article will not attempt to make a bond market forecast. It will, however, attempt to show how interest rate hedging can be an important alternative to short duration or floating rate bonds (whether they represent a long term position or represent a tactical position in a rising rate environment). Investing in bonds with “average” duration—say, 5-10 years—and hedging the interest rate risk by shorting Treasury bonds or futures of similar duration can substantially offset interest rate risk while delivering higher yields than short-term instruments.
The alchemy of the credit term premium
It is of course impossible to buy long-duration Treasurys, hedge out the interest rate risk, and have a yield in excess of T-bill rates. That’s why we feel hedging the interest rate risk of a position in the Barclays US Aggregate Bond Index—an index comprised of roughly 1/3 U.S. Treasurys—is not necessarily effective. After all, hedging has a cost, so hedging U.S. Treasurys simply recreates cash, at a cost.
How is it, then, that one could invest in longer duration investment grade and high yield bonds, hedge out the interest rate risk, and have a yield in excess of floating rate instruments? The alchemy here comes from the credit term premium, which—all else being equal—is the spread between Treasury and non-Treasury securities. Credit spreads are generally wider for longer duration bonds. So, even after hedging out interest rate risk, the yields on interest rate hedged investment grade and high yield bonds of “average” duration have been higher than their floating rate counterparts.
That’s not a risk-free proposition, of course. Movements in credit spreads could be proportionally larger for bonds of “average” duration than they’d be for bonds of shorter duration or floating rate instruments. Additionally, there’s a cost associated with hedging, and any hedge has the potential to fail. Still, it is a compelling source of additional yield—one that is often sought by credit arbitrage hedge funds but is also achievable through an index-based approach.
Divorcing credit exposure from interest rate exposure
Another benefit of this approach is that it separates the credit exposure decision from the interest rate exposure decision. Many investors have been conflating the two of late, most obviously by investing in bank loans. While the floating rate aspect of bank loans can reduce interest rate exposure, bank loans are, by and large, below investment grade. Many investors have likely unwittingly increased credit exposure through these investments.
Avoiding unintended portfolio consequences
This brings us to another key benefit of an interest rate hedging approach—it’s an interesting way to separate the two exposures. That’s what the Citi Treasury rate-hedged indexes seek to accomplish. Investors can reduce their interest rate exposure with either investment grade or high yield choices, each of which—with the exception of their interest rate hedge—looks very much like “regular” investment grade and high yield bond allocations. So they can directly replace all or portions of those sleeves without any unintended consequences to an asset allocation. Then, separately, investors can decide if they want more or less investment grade or high yield in their allocations, depending on their current view of credit spreads.
In summary, an interest rate hedged approach can provide higher yields than short duration or floating rate bonds, while maintaining a zero duration target. It’s an important idea for investors seeking to generate additional yield from a long term position in short duration or floating rate bonds. It’s also a key concept for investors seeking to reduce the duration of their bond portfolios in a rising rate environment.
The ProShares Investment Grade-Interest Rate Hedged ETF (IGHG) and ProShares High Yield Interest Rate Hedged ETF (HYHG) strategies have built-in hedges against the effects of rising interest rates by using short Treasury futures to target a duration of zero.
Simeon Hyman is Head of Investment Strategy for ProShares.