With Treasury yields regaining ground as market volatility dissipates and inflation expectations rise, rate-hedged bond exchange traded funds are beginning to outperform.
The yield on benchmark 10-year Treasuries are back to 1.92% Monday, compared to a low of 1.567% in mid-February. Treasuries continued to slip Monday as yields pushed higher after two Federal Reserve officials revealed bullish projections on inflation, reports Caren Brettell for Reuters. Higher inflation makes fixed-income assets less attractive due to their lower real yield, or yield after inflation.
Richmond Fed President Jeffrey Lacker argued that inflation will likely accelerate in the coming years and move toward the Federal Reserve’s 2% target. San Francisco Fed President John Williams also told Market News International that he would push for another interest rate hike as early as the April meeting, citing “very encouraging” inflation rates.
Consequently, as Treasury yields rose, zero-duration or interest-rate-hedged ETFs that try to negate the negative effects of higher rates have done their job and outperformed the non-hedged bond funds.
For instance, over the past month, the iShares Interest Rate Hedged Corporate Bond ETF (NYSEArca: LQDH) rose 3.9%, Deutsche X-trackers Investment Grade Bond – Interest Rate Hedged ETF (NYSEArca: IGIH) gained 3.9% and ProShares Investment Grade-Interest Rate Hedged ETF (BATS: IGHG) increased 4.5%. Meanwhile, the widely observed iShares iBoxx $ Investment Grade Corporate Bond ETF (NYESArca: LQD) added 3.1%.
These new types of zero duration or negative duration ETFs hold long-term bonds, but they will take short positions in Treasuries or Treasury futures contracts to hedge against potential losses if interest rates rise. 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 low duration would translate to a smaller sensitivity to shifting rates. Moreover, as yields have been inching higher and Treasury bond prices fell over recent weeks, the short Treasury positions helped bolster returns in the rate-hedged bond ETFs.
LQDH has an effective duration of 0.79 years – a 1% rise in interest rates would only translate to about a 0.79% decline in the fund’s price – and a 3.42% 30-day SEC yield. IGHG has a -0.10 year duration and a 3.93% 30-day SEC yield. In contrast, LQD has a 8.25 year duration and a 3.51% 30-day SEC yield.
However, potential investors should be aware that since these bond funds hold short Treasury positions, the rate-hedged ETFs may underperform non-hedged bond ETFs if Treasury yields fall and Treasuries begin to rebound.