Most fixed-income investors have shifted toward short-term bond funds in anticipation of a rising interest rate environment. However, through a targeted rate-hedged bond exchange traded fund strategy, investors can remove rate risk altogether.
“To prepare for rising interest rates, many investors move to short-term bond funds. This may help reduce their interest rate risk, but it doesn’t eliminate it. Is there a way to virtually eliminate it? There is – with interest rate hedged bond funds,” according to a ProShares note.
For example, the ProShares Investment Grade-Interest Rate Hedged ETF (BATS: IGHG) and ProShares High Yield Interest Rate Hedged ETF (BATS: HYHG) are interest-rate hedged bond ETFs whose underlying indices target 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.
“The Index maintains exposure to credit opportunities as a primary source of return, while the hedge is designed to alleviate the drag on return when interest rates rise. The Index has a history of performing well during periods of rising rates,” according to ProShares.
The rate-hedged bond ETFs 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.
On the other hand, most fixed-income investors look to short duration bond funds since the lower duration translate to a diminished sensitivity to changes in interest rates. However, short-term bond funds will still be negatively affected by higher rates.
Alternatively, the zero-duration strategy should help an interest-rate-hedged ETF outperform its non-hedged fund options if rates continue to rise.
“Short-term bond funds are not the only answer to rising rates,” ProShares said in a note. “Another – perhaps better – way to remain invested in bonds is to remove the interest rate risk entirely with a build-in hedge. If rates continue to rise, now may be a good time to prepare with an interest rate hedged bond ETF.”
For more information on the fixed-income market, visit our bond ETFs category.