Short-term fixed-income assets have been a traditional safe-haven bet in a rising interest rate environment, but they are still negatively affected by higher rates. Alternatively, bond investors can turn to interest-rate hedged exchange traded funds to negate rate risk.
While short-term bonds may help diminish interest rate risk, what many may not realize is that by shifting down the yield curve, bond investors shortchange their potential returns in two ways: moving to short-term debt does not eliminate rate risk and the short-term bonds have less exposure to credit opportunities, a key driver of bond returns, according to a ProShares note.
“Short term high yield bond funds help investors reduce their interest rate risk, but they have shortcomings. If you’re looking for a potentially better solution to rising rates, consider an interest rate hedge bond ETF,” ProShares said.
For example, ETF investors can consider rate hedged ETF strategies to eliminate the rising rate risks, such as the ProShares Investment Grade-Interest Rate Hedged ETF (BATS: IGHG) for investment-grade corporate debt exposure, or those 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.
This alternative approach tries to eliminate interest rate risk while maintaining full exposure to credit opportunities.
“It’s important because, when rates rise, credit spreads have typically tightened and boosted returns,” according to ProShares.
The two rate-hedged bond ETFs achieve their diminished rate-risk status by shorting Treasury notes so that the underlying portfolio shows a near-zero duration – duration is a measure of sensitivity to changes in interest rates, so a zero duration translates to no sensitivity to changes. For example, IGHG shows a -0.02 year duration and a 3.50% 30-day SEC yield, and HYHG has a -0.07 year duration and a 5.21% 30-day SEC yield.
By hedging away rate risk, bond investors can focus on the underlying debt securities without fear of the negative effects of rising interest rates, maintaining their current level of income generation and potentially capitalizing on the tightening credit spreads.
For more information on the fixed-income space, visit our bond ETFs category.