Ahead of the Federal Reserve interest rate hike, fixed-income investors are beginning to think about ways to position their portfolios. One way to help protect a portfolio from rate risks is through interest-rate-hedged exchange traded funds.
On the recent webcast, Managing Risk with Interest-Rate-Hedged ETFs, Bill Chepolis, Managing Director and Co-Head of Fixed Income for North America for Deutsche Asset & Wealth Management, explains how bond funds with longer durations could cause a drag on performance as interest rates rise.
For instance, Chepolis points out that a Treasury bond fund with a 20-year duration could experience a 20% drag on performance if interest rates were to rise 1%.
Peyton Studebaker, Managing Director and Portfolio Management at Caprin Asset Management, argues that the use of ETFs as part of fixed-income portfolio is helpful in navigating the bond markets and in responding to a rising interest rate environment.
Studebaker pointed out that Caprin has included leveraged inverse Treasury bond ETFs to help manage rate risk. The strategist explains that short Treasury position helped support a portfolio through rate move while protecting income generation.
Yield remains an important part of total return, and there are alternative investment strategies other than moving down the yield curve to hedge rate risk. Through a small short Treasury position, an fixed-income investor can hedge against the negative effects of rising rates and still generate the income he or she is accustomed to.
In March, Deutsche AWM introduced 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). HYIH’s underlying holdings show a yield to worst of 4.9%. IGIH has a yield to worst of 1.39% and EMIH has a yield to worst of 3.68%. [Deutsche Adds Three New Bond ETFs]
IGIH tracks investment-grade corporate bonds, HYIH includes a group of speculative-grade junk bonds and EMIH follows U.S.-dollar-denominated emerging market bonds. However, unlike traditional bond ETFs, these options try to mitigate interest rate sensitivity across the yield curve in a rising rate environment by taking short positions in U.S. Treasury futures.
Lance Allen, ETF Regional Vice President for Deutsche Asset & Wealth Management, points out that the ETFs are first created through a long portfolio of their respective fixed-income asset categories and then include five U.S. Treasuries corresponding to two-year, five-year, 10-year, long and ultra-long U.S. Treasury futures, depending on the long bond position’s duration.
Through their short positions, IGIH, HYIH, and EMIH have a modified duration of about zero years. Duration is a measure of a bond fund’s sensitivity to changes in interest rates. Consequently, since these bond ETFs essentially have a zero duration, a rising interest rate would not negatively affect the investments. However, potential investors should keep in mind that if interest rates were to fall, these hedged bond ETFs could underperform non-hedged options.
“Interest-rate-hedged ETFs can work in tandem with existing fixed-income holdings and as risk-management tools to target a specified duration and interest-rate exposure,” Allen said.
Financial advisors who are interested in learning more about hedged fixed-income strategies can listen to the webcast here on demand.