Fixed-income investors have traditionally shifted down the yield curve when the Federal Reserve embarks on a tighter monetary policy to hedge against rate risk, but this comes with its own shortcomings. Alternatively, exchange traded fund investors may have a more appealing option through targeted interest-rate hedged strategies.
While investors may shift their fixed-income holdings to short-term bonds to diminish rate risk, they may not realize that they will be shortchanging their potential returns. Specifically, moving to short-term debt reduces rate risk but does not eliminate it, and short-term bonds have less exposure to credit opportunities, a key driver of returns, according to a ProShares note.
As an alternative to the traditional shift toward the short end of the yield curve, investors can eliminate rate risk and still maintain full exposure to credit opportunities through an interest rate-hedged bond ETF.
“An alternative approach is to seek to eliminate interest rate risk while maintaining full exposure to credit opportunities. This is what an interest rate hedged strategy aims to do. It’s important because, when rates rise, credit spreads have typically tightened and boosted returns,” according to a ProShares note.
For instance, the ProShares Investment Grade-Interest Rate Hedged ETF (BATS: IGHG) tries to reflect the performance of the Citi Corporate Investment Grade Treasury Rate Hedged Index, which provides exposure to a diversified portfolio of investment-grade long-term bonds with a built-in interest rate hedge. The ETF will maintain full exposure to credit risk as a source of return while simultaneously incorporating a hedge to alleviate the impact of rising rates.
To achieve its lower rate risk exposure and maintain its return potential, IGHG takes short positions in U.S. Treasuries to achieve a zero duration target. With a zero duration, the bond ETF has 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.
For more information on the fixed-income markets, visit our bond ETFs category.