The Federal Reserve is confident in the U.S. economy and is set to roll back its $4.5 trillion balance sheet, sending fixed-income investors scrambling.
Nevertheless, bond investors may look to an alternative ETF to hedge against a potentially rising rate environment ahead.
The Fed announced Wednesday that it will begin to gradually unwind its massive stimulus program in October, reducing its holdings by $10 billion and raising that amount gradually in the months ahead, reports Heather Long for the Washington Post.
“The basic message here is U.S. economic performance has been good,” Federal Reserve Board Chair Janet L. Yellen said on Wednesday.
As the Fed unwinds its copious stimulus program, the central bank could dump hundreds of billions of dollars worth of U.S. government bonds onto the market, depressing fixed-income prices and pushing yields higher. Consequently, yields on 10-year Treasury notes already popped to 2.28% Wednesday in response to Yellen’s speech.
As yields rise, fixed-income investors may find it harder to sit with traditional bond exposures.
“Not doing anything would be a risky move, RISE can take some of that off the table,” Bryce Doty of Sit Investments said in a note.
The Sit Rising Rate ETF (NYSEArca: RISE) brings an institutional-level interest rate hedging strategy to everyday investors. With many fixed income investors concerned about the effects of higher interest rates, RISE could be an ideal ETF for a rising rate environment.
The Sit Rising Rate ETF is designed to capitalize on rising rates by holding derivative hedges tied to two-, five- and 10-year U.S. Treasuries.
The weighting of the Treasury Instruments constituting the Benchmark Portfolio Index will be based on each maturity’s duration contribution. The expected range for the duration weighted percentage of the 2 year and 5 year maturity Treasury Instruments will be from 30% to 70%. Additionally, the expected range for the duration weighted percentage of the 10 year maturity Treasury Instruments will be from 5% to 25%, according to Rise.
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The interest rate ETF tries to achieve a negative duration through its short Treasury positions to hedge against potential losses if interest rates rise – bond prices have an inverse relationship to interest rates, so rising rates corresponds with falling bond prices.
Consequently, investors may find that the negative duration ETF tries to profit off a rising rate environment by heavily using short contracts to capitalize on falling bond prices if rates do rise. However, due to the more aggressive nature of this strategy, these types of ETFs will underperform if rates fall.
For more information on the fixed-income market, visit our bond ETFs category.