As more shy away from safe-haven bets and markets anticipate a tighter monetary policy out of the Federal Reserve ahead, fixed-income investors may be up against an uphill battle, facing a rising interest rate environment. Nevertheless, there are targeted bond exchange traded strategies catered to fight against rate risk.
With yields on benchmark 10-year Treasury bonds creeping higher on diminished demand for safe haven assets, investment-grade debt has slipped. Since the April 18 low, yields on 10-year Treasury notes have risen a little over 20 basis points to 2.407%.
Meanwhile, popular bond ETF plays, like the iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSEArca: LQD), have dipped – LQD fell 0.1% over the past week.
ETF investors, though, can consider rate hedged ETF strategies to eliminate the rising rate risks. For instance, the ProShares Investment Grade-Interest Rate Hedged ETF (BATS: IGHG) gained 0.7%.
Similarly, investors interested in high-yield, speculative-grade debt can also look at the ProShares High Yield Interest Rate Hedged ETF (BATS: HYHG) for a rate hedged junk bond play.
“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.”
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.