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.
Related: Hedged Bond ETFs Outperform as Treasury Yields Rise
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]For example, the popular investment-grade corporate bond ETF, iShares iBoxx $ Investment Grade Corporate Bond ETF (NYESArca: LQD), has a 8.32 year effective duration and a 3.19% 30-day SEC yield, so a 1% increase in interest rates could translate to a 8.32% decline in the ETF’s price. Consequently, many have shifted down the yield curve to lower duration bond ETFs as a means to hedge against rising interest rates – a lower duration means that the fund would be less sensitive and exhibit a lower decline in the event of rising interest rates.
Related: Control Rate Risk Exposure with Low-Duration Bond ETFs
Alternatively, something like the iShares Interest Rate Hedged Corporate Bond ETF (NYSEArca: LQDH) holds short positions in interest rate swaps, which provides the rate-hedged ETF with a 0.03 effective duration – a 1% rise in interest rates would translate to a 0.03% decline in the funds price, and LQDH would still offer up a 3.43% 30-day SEC yield.
Investors who are interested in the rate-hedged bond strategy have a number of ETF options available.
Interest Rate-Hedged ETFs:
- Deutsche X-trackers Investment Grade Bond – Interest Rate Hedged ETF (NYSEArca: IGIH)
- Deutsche X-trackers High Yield Corporate Bond – Interest Rate Hedged ETF(NYSEArca: HYIH)
- Deutsche X-trackers Emerging Markets Bond – Interest Rate Hedged ETF (NYSEArca: EMIH)
- iShares Interest Rate Hedged Corporate Bond ETF (NYSEArca: LQDH)
- iShares Interest Rate Hedged Emerging Markets Bond ETF (NYSEArca: EMBH)
- iShares Interest Rate Hedged 10+ Year Credit Bond ETF (NYSEArca: CLYH)
- iShares Interest Rate Hedged High Yield Bond ETF (NYSEArca: HYGH)
- Market Vectors Treasury-Hedged High Yield Bond ETF (NYSEArca: THHY)
- ProShares Investment Grade-Interest Rate Hedged ETF (BATS: IGHG)
- ProShares High Yield Interest Rate Hedged ETF (BATS: HYHG)
- WisdomTree Barclays U.S. Aggregate Bond Zero Duration Fund (NYSEArca: AGZD)
- WisdomTree Barclays U.S. Aggregate Bond Negative Duration Fund (NYSEArca: AGND)
- WisdomTree BofA Merrill Lynch High Yield Bond Zero Duration Fund (NYSEArca: HYZD)
- WisdomTree BofA Merrill Lynch High Yield Bond Negative Duration Fund (NYSEArca: HYND)