As we witnessed this year, interest rates can begin to rise ahead of any Federal Reserve rate change. Consequently, investors can utilize interest-rate hedged bond ETF strategies to weather the storm.
“During the most recent run-up in interest rates from April 1 through June 26, the yield on 10-year Treasurys rose from 185 bps to 247 pbs,” according to a ProShares research note. “Not only did the Fed not raise interest rates during that period, but market expectations fro a future Fed increase actually declined. Investors who were waiting for the Fed to start raising rates before modifying their bond portfolios likely suffered losses. For some, that 62 pbs rise in 10-year Treasury yields may have translated into significant losses.”
During the April and June months, fixed-income assets sold off as rates ticked higher. However, investors may have diminished the losses with a rate-hedged bond ETF.
For instance, the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEArca: HYG) fell 1.7% between April 1 and June 26 while the ProShares High Yield Interest Rate Hedged ETF (BATS: HYHG) gained 0.9%. The iShares iBoxx $ Investment Grade Corporate Bond ETF (NYESArca: LQD) declined 5.4% over the same period while the ProShares Investment Grade-Interest Rate Hedged ETF (BATS: IGHG) only dipped 0.4%. [Hedged Bond ETFs to Diminish Rate Risk]
“The Fed Funds Rate and market interest rates often diverge,” ProShares said. “Investors waiting for the Fed to act should focus instead on what the market is doing and adjust their portfolios accordingly.”
Unlike traditional bond ETFs, the rate-hedged bond ETFs try to mitigate the negative effects of a rising rate environment through shorting Treasury futures to match the overall duration of their diversified bond holdings. The hedge is also rebalanced monthly to keep pace with changing market conditions.
Consequently, the two ETFs have relatively no duration risk. Specifically, HYHG has an effective duration of -0.3 years and IGHG has an effective duration of -0.1 years – duration is a measure of a bond fund’s sensitivity to changes in interest rates. If interest rates were to rise 1%, HYHG would actually rise about 0.3% and IGHG would gain 0.1% due to their short Treasury positions.
Nevertheless, potential investors should be aware that these types of zero-duration, hedged bond ETFs may underperform a non-hedged version if rates decline.
Looking further out, these types of hedged-bond ETFs could provide suitable exposure to the fixed-income market in a rising interest environment, especially as the Federal Reserve plans on hiking rates sometime later this year.
For more information on the fixed-income market, visit our bond ETFs category.
Max Chen contributed to this article.