Rate Hedged ETFs Show Their Mettle

Fixed income exchange traded funds that hedge against interest rate risk may have seemed like a novel idea when these funds started appearing several years, but some of these products are proving solid in real world applications as the Federal Reserve boosts borrowing costs.

The Federal Reserve has raised interest rates three times this year and is eyeing another rate hike in December, moves that are plaguing some traditional fixed income exchange traded funds.

Investment-grade corporate bond ETFs that can help investors hedge rate risk while maintaining exposure to credit opportunities include the ProShares Investment Grade—Intr Rt Hdgd (CBOE: IGHG) and the iShares Interest Rate Hedged Corp Bd ETF (NYSEArca: LQDH).

IGHG tracks the performance of the Citi Corporate Investment Grade (Treasury Rate-Hedged) Index with long positions in investment grade corporate bonds issued by both U.S. and foreign domiciled companies. This is particularly important during market downturns when the propensity for a company to default on its debt is higher. As such, IGHG focuses on investment-grade issues to reduce credit risk.

Rate hedged ETF “have performed well enough for retirees to give them serious consideration. But you should know that hedging is a messy business, and there inevitably will be times—hopefully temporary—when the hedges don’t work,” reports MarketWatch.

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IGHG has an effective duration of just 0.87 years, but the fund does not skimp on income as highlighted by a 30-day SEC yield of 4.60%.

Ten-year Treasury yields hit all-time lows about two and a half years ago. Since then, interest rate hedged ETFs, including LQDH and IGHG have delivered positive returns. There are short periods when these products can generate negative returns and investors should understand why that happens.

“Each of these ETFs owns a basket of bonds with different maturities, and hedging that basket requires an implicit bet on the future shape and slope of the yield curve. Such bets can either be better or worse and, needless to say, so far this year these ETFs’ hedges haven’t been perfect,” reports MarketWatch.

Still, over the past year, IGHG is outperforming the largest investment-grade corporate bond ETF, which is not rate hedged, by 150 basis points.

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