Bond prices and rates have an inverse relationship. When the Federal Reserve embarks on a rising rate policy or when investors shift away from safety plays like Treasuries and rates rise, bond prices typically 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.
Fixed-income investors traditionally look to short-term debt as a means to diminish the rate risk, sacrificing potential returns or yields in exchange for the lower sensitivity to rate changes. While short-term bonds may stand up better against rising rates, they are still negatively affected by higher rates.
As an alternative, investors should consider interest-rate hedged bond ETFs that 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.
“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, HYHG’s underlying index has an effective duration of -0.16 years and IGHG’s underlying index has an effective duration of 0.05 years – a 1% rise in interest rates would roughly translate to a +0.16% gain for HYHG and a -0.05% loss for IGHG. Despite the lower durations, the two ETFs still help generate attractive yields as HYHG comes with a 5.88% 30-day SEC yield and IGHG shows a 3.65% 30-day SEC yield.
“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.