Bond Investors Should Consider Rate-Hedged ETF Options

For instance, the popular investment-grade corporate bond ETF, iShares iBoxx $ Investment Grade Corporate Bond ETF (NYESArca: LQD), has a 8.45 year effective duration and a 2.97% 30-day SEC yield, so a 1% increase in interest rates could translate to a 8.45% decline in the ETF’s price.

On the other hand, 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 -0.01 effective duration – a 1% rise in interest rates would translate to a 0.01% increase in the funds price, and LQDH offers up a 2.97% 30-day SEC yield.

The strategy should help an interest-rate-hedged ETF outperform its non-hedged options if rates continue to rise. For instance, since the yield on benchmark 10-year Treasuries rose over the past three months, the non-hedged LQD fell 0.6% while the hedged LQDH gained 1.3%. Similarly, the Deutsche X-trackers Investment Grade Bond – Interest Rate Hedged ETF (NYSEArca: IGIH) increased 2.5% and the ProShares Investment Grade-Interest Rate Hedged ETF (BATS: IGHG) returned 2.7% over the same period.

The popular iShares iBoxx $ High Yield Corporate Bond ETF (NYSEArca: HYG), which has a 3.94 year duration and a 5.35% 30-day SEC yield, has also underpeformed its rate-hedged counterparts as yields on Treasuries ticked higher. Over the past three months, HYG was up 2.6%, whereas iShares Interest Rate Hedged High Yield Bond ETF (NYSEArca: HYGH) was up 3.7%, Market Vectors Treasury-Hedged High Yield Bond ETF (NYSEArca: THHY) gained 4.2%, ProShares High Yield Interest Rate Hedged ETF (BATS: HYHG) increased 3.7% and WisdomTree BofA Merrill Lynch High Yield Bond Zero Duration Fund (NYSEArca: HYZD) advanced 4.2%.

Income-minded investors don’t need to give up bond allocations in a rising interest rate environment. Look to alternative strategies like rate-hedged ETFs to keep generating attractive yields while mitigating the negative effects of higher rates.