With yields on Treasuries pushing higher and more investors pricing in a Federal Reserve rate hike, the once outperforming bond market is losing its momentum. Alternatively, investors who rely on the income generation should consider rate-hedged bond exchange traded funds.
Since yields on benchmark 10-year Treasuries bottomed out at around 1.36% in early July, yields on 10-year notes have increased to 1.79%, weighing on the bond markets, with a popular Treasury bond ETF play, the iShares 20+ Year Treasury Bond ETF (NYSEArca: TLT), testing its support at its 200-day simple moving average.
The bond market continued to weaken, with yields pushing higher, after minutes of the September Federal Reserve meeting revealed several U.S. central bankers arguing for a rate hike is needed “relatively soon.” Speculation of a Fed interest rate hike as soon as the upcoming December meeting has been gaining traction on improved U.S. economic data, including the steadily growing employment numbers and rising inflation levels. Looking at Federal funds futures for December delivery, options traders were pricing in a 69% chance the Fed would hike short-term interest rates at its December 13 to 14 policy meeting.
Fixed-income investors would typically move down the yield curve to hedge against rising interest rate risks. However, while moving down the yield curve provides a greater level of safety, lower duration bond funds come with less appealing yields.
Bond ETF investors, though, do not need to sacrifice their yield generation to diminish rate risk. Alternatively, investors can look to rate-hedged or zero-duration bond ETFs. The group of interest rate-hedged or zero duration ETFs hold long-term bonds, but they also simultaneously short Treasuries or Treasury futures contracts to hedge against potential losses if interest rates rise.
Unlike traditional fixed-income ETF options, rate-hedged bond ETFs diminish the negative effects of rising rates through short positions in Treasury futures to reduce the overall duration. Due to their near-zero durations, the bond funds should show little to no sensitivity to changes in interest rates. These types of hedged-bond ETFs could provide suitable exposure to the fixed-income market in a rising interest environment ahead.
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.