With yields rising and many anticipating an imminent Federal Reserve interest rate hike, bond investors can consider an alternative, strategic interest-rate-hedging exchange traded fund strategy to diminish the negative effects of the Fed’s expected rate normalization.
The Sit Rising Rate ETF (NYSEArca: RISE) brings an institutional-level interest rate hedging strategy to everyday investors. With many fixed income investors concerned about the effects of higher interest rates, RISE could be an ideal ETF for a rising rate environment.
RISE “works by targeting a negative 10-year duration using futures and options on 2, 5 and 10-year maturity Treasury futures contracts. RISE can be used strategically as a hedge, allowing investors to keep their bond positions, but providing protection when rates rise,” reports ETF Daily News.
Some 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.
With government bonds provident higher returns, some are looking back to Treasuries and other high-grade debt again as a hedge against further market turbulence.
RISE’s underlying portfolio is rebalanced monthly to maintain a negative 10-year average effective duration through short positions in Treasury instruments.
Negative duration bond ETFs try to profit off a rising rate environment by heavily using short contracts to capitalize on falling bond prices if rates do rise. However, due to the more aggressive nature of this strategy, these types of ETFs will underperform if rates fall.
With a negative 10-year duration, investors may find that a 1% increase in U.S. Treasury yields results in about a 10% return in RISE’s price. So the price moves nearly 10 times the change in yield. Duration is a measure of a bond funds sensitivity to changes in interest rates, so a large effective duration reflects a greater sensitivity in the bond fund’s price to changes in rates.
For more information on the fixed-income market, visit our bond ETFs category.