Fixed-income investors typically rely on short-term debt to diminish risks in a rising rate environment, but they are still subject to rate risk. Exchange traded fund investors, though, can turn to targeted rate-hedged bond strategies that try to negate rising rate risks altogether.
Bond prices and rates have an inverse relationship. When the Federal Reserve embarks on a rising rate policy with three more rate hikes expected this year, bond prices will fall. How much bond funds fall will depend on their duration, or the sensitivity to changes in interest rates, so a bond fund with a higher duration, the more sensitive it is to interest rates and the more it stands to lose or gain when rates fluctuate.
As we have witnessed, long-term bond funds carry significant interest rate risk, plunging when rates spiked due to their high duration. Fixed-income investors have traditionally turned to short-term bonds to diminish the rate risk, sacrificing potential returns in exchange. While short-term bonds may stand up better against rising rates, they are still negatively affected by higher rates.
Alternatively, investors should consider interest-rate hedged bond ETFs with a zero duration. With a zero duration, these bond ETFs have no sensitivity to changes in interest rates, providing investors access to higher yields and outperforming other non-hedged bond funds with similar durations when rates rise.
“Interest rate hedged bond funds go a step further than short-term bond funds,” ProShares said in a research note. “They offer a long-term bond portfolio, but include a built-in hedge that targets a duration of zero to eliminate interest rate risk.”
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.
HYHG and IGHG “maintain full exposure to credit risk as a primary source of return while the built-in hedges alleviate the drag on returns caused by rising interest rates,” ProShares said.
For more information on the fixed-income market, visit our bond ETFs category.