Bond fund investors would typically go down the yield curve to hedge against rising interest rates. Alternatively, exchange traded fund (ETF) investors can also go on the offensive with a zero-duration or rate-hedged strategy.
Rising interest rates have a negative effect on bond funds. As rates rise, older debt securities with lower rates are less attractive than newer issues that come out with the higher rates. Consequently, the less appealing older bonds will see prices fall in response to the diminished demand in a rising rate environment.
Related: Mortgage Up With These 7 Bond ETFs
Bond funds, which may hold a collection of debt securities to maintain their target duration strategy, will also see their underlying holdings decline in value. Additionally, the funds may lose out when selling a less valued older debt security for newer issues with higher yields.
Fixed-income investors would traditionally move down the yield curve to hedge against the rate risks – bond funds with a lower duration would help diminish a fixed-income portfolios sensitivity to changes in the interest rate. However, while moving down the yield curve provides a greater level of safety, the lower duration bond funds come with less appealing yields.
Bond traders, though, do not need to sacrifice yield-generation to diminish rate risk. Instead, investors can look to rate-hedged or zero-duration bond ETFs. The 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_stories]
Unlike traditional fixed-income ETFs, rate-hedged bond ETFs mitigate the negative effects of a rising rate environment through shorting Treasury futures to diminish the overall duration of their diversified bond holdings. Specifically, due to their near-zero durations, the bond funds should show little to no sensitivity to changes in interest rates. 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.