A rising interest rate environment will weigh on fixed-income portfolios. Bond traders do not need to sacrifice yield-generation to diminish rate risk. Instead, investors can look to rate-hedged or zero-duration bond exchange traded funds.
A relatively new breed of interest rate-hedged, zero duration ETFs hold long-term bonds, but they will simultaneously short Treasuries or Treasury futures contracts to hedge against potential losses if interest rates rise – bond prices have an inverse relationship to interest rates, so rising rates corresponds with falling bond prices.
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. 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.
The long/short bond ETFs can provide an alternative means to invest in fixed-income assets without sacrificing yields while diminishing the negative effects of rising rates on a bond fund’s price. Specifically, due to their near-zero durations, the bond funds should show little sensitivity to changes in interest rates.[related_stories]