As the debate rages surrounding the timing of the first Federal Reserve (Fed) rate hike, we continue to discuss the potential tradeoffs surrounding this inevitable shift in policy. While some investors may be content to ride out the waning bull market in bonds, others may seek to position more tactically. We continue to believe that asymmetric risks remain in the bond market. As a result, investors should consider hedging interest rate risk.

Historically, investors have quantified the amount of interest rate risk in their portfolios via duration. For every 1% move higher in interest rates, a five-year duration bond’s price is expected to fall by approximately 5%. For those interested in expressing a view on rising U.S. rates, a negative duration bond strategy could provide investors a way to profit from rising rates (and lower bond prices).

As in most markets, there is no free lunch. One of the hurdles associated with a “short” bond position is the costs of maintaining that position. What we mean by costs is that if a long position in a bond pays the holder interest, then a short position in that same security will require the short to pay the interest. A long bond position is akin to lending; a short position is akin to borrowing. For investors that believe higher interest rates are coming, timing is a crucial factor: time is literally money due to the cost of being short. Unless interest rates rise (and bond prices fall), the short position will experience negative total returns due to the impact of negative carry.

One option to help defray the costs of the short position is to invest in a portfolio of bonds (positive carry) and then “overhedge” the portfolio by selling longer maturity securities to achieve a negative duration target. Through our collaboration with Barclays and Bank of America Merrill Lynch, WisdomTree has established strategies that are constructed on this simple premise.

Negative Duration Mechanics

As investors have become more comfortable with currency-hedged equity strategies that isolate equity risk from currency risk, interest-rate-hedged bond strategies operate on a similar principle. In creating our suite of rising-rate strategies, we sought to focus on traditional bond indexes that investors already have exposure to today. The only difference in our approach is that a second adjustment factor is applied via the interest rate overlay. As figure 1 shows, the negative duration variant of the Barclays U.S. Aggregate Bond Index (Agg)1 can be thought of as a combination of two portfolios: a portfolio of bonds and a portfolio of short Treasury positions. The bond portfolio provides income that helps defray the cost of the short positions. In a rising-rate environment, the profits from the short positions help offset losses from the long bond position, thus generating positive total returns.

Figure 1: Under the Hood of Negative Duration

In our view, the best way to understand these strategies is to examine the net effect of a rise in rates. On January 30, interest rates across the U.S. yield curve made fresh year-to-date lows. Over the next several weeks, interest rates rose, resulting in losses for unhedged positions in the Agg. As figure 2 shows, an unhedged portfolio fell by approximately 1.45%, whereas the negative duration strategy rose by 2.86%.2 Over the same period, the five-year U.S. Treasury bond yield rose by nearly 54 basis points, implying a price loss of approximately 2.58%.3 As we have mentioned previously, U.S. Treasury bonds continue to trade like growth stocks: total returns are almost exclusively being driven by price returns.

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