The debt market has been reeling as bond yields rose. However, fixed-income investors can hedge against rising rates through alternative bond exchange traded fund strategies.
On the recent webcast, The Growing Risk of Normalizing Interest Rates, Simeon Hyman, Head of Investment Strategy at ProShares, pointed to a targeted zero-duration bond fund strategy to diminish rate risks. Through a zero-duration strategy, investors would more or less negate the negative effects of rising interest rates on their bond investments.
Many advisors and investors have already turned to common hedging strategies like shorter-term duration bonds ahead of a potential rate hike. In a survey of financial advisors on the webcast, 93% of respondents believed that a December Federal Reserve rate hike is imminent, with 62% turning to short-duration funds as the go-to hedge.
“Rising rates can still significantly impact short-term bond funds,” Hyman warned. “A strategy that targets a duration of zero may have even less sensitivity – potentially no sensitivity – to rising interest rates. Of course, you can employ a method where you short out the duration exposure yourself as well.”
For example, the ProShares Investment Grade-Interest Rate Hedged ETF (BATS: IGHG) and ProShares High Yield Interest Rate Hedged ETF (BATS: HYHG) hold short positions in interest rate swaps to provide about a 0 year effective duration – duration is a measure of a bond fund’s sensitivity to changes in interest rates so a zero duration reflects no sensitivity to changes. Consequently, the zero-duration strategy should help an interest-rate-hedged ETF outperform its non-hedged fund options if rates continue to rise.
“Combined, the long and short portfolios are designed to target a duration of zero at each monthly rebalancing,” Hyman said. “In this manner, the ETFs attempt to hedge out the interest rate risk of the long holdings, while leaving other drivers of risk and return unaffected.”
Nevertheless, potential investors should be aware that these rate-hedged corporate bond ETFs are still subject to credit risks. The funds may also underperform non-hedged bond funds if Treasury prices increase or yields retreat.
Furthermore, investors can also hedge against further bond market drawdowns through inverse or bearish ETF strategies that are designed to reflect the daily movements in the opposite direction of a benchmark index.
“The primary feature of using an inverse bond ETF hedge is that you can keep the majority of your client’s portfolio – the long-term asset allocation, the risk tolerance, and even the majority of income – completely intact,” Hyman added. “You may be able to reduce your client’s bond risk without selling highly appreciated bonds to do it.”
For instance, the ProShares Short 20+ Year Treasury (NYSEArca: TBF), which takes the simple inverse or -100% daily performance of Treasury bonds that mature in over 20 years. For more aggressive bond traders, the ProShares UltraShort 20+ Year Treasury (NYSEArca: TBT) tries to reflect the -2x or -200% daily performance of the ICE U.S. 20+ Year Treasury Bond Index, and he ProShares UltraPro Short 20+ Year Treasury (NYSEArca: TTT) takes the -3x or -300% daily performance of the ICE U.S. 20+ Year Treasury Bond Index.
To target shorter duration Treasury bonds, the ProShares Short 7-10 Year Treasury (NYSEArca: TBX) tries to track the inverse, or -100%, daily performance of the ICE U.S. 7-10 Year Treasury Bond Index. For those looking for a larger bet against Treasury prices and are willing to taking on the added risk, ProShares UltraShort 7-10 Year Treasury (NYSEArca: PST), tries to track two times the inverse, or -200%, daily performance of the ICE U.S. 7-10 Year Treasury Bond Index, and the ProShares UltraShort 3-7 Year Treasury ETF (NYSEArca: TBZ) takes the -200% daily performance of the ICE U.S. Treasury 3-7 Year Bond Index.
Potential traders should also keep in mind the risks associated with these geared products and be aware that leveraged and inverse ETFs are designed to produce their target strategies on a daily basis.
Financial advisors interested in learning more about positioning a fixed-income portfolio in a rising rate environment can watch the webcast here on demand.