How to Hedge Rate Risk With ETFs

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.

Despite growing demand for bond ETFs in 2018, one of the industry’s oldest and largest products is among the least popular this year,” said CFRA Research Director of ETF & Mutual Fund Research Todd Rosenbluth in a note out Monday. “A nearly 5% decline and high sensitivity to rising interest rates is a likely driver of the outflows, yet we find it surprising that investors have not gravitated toward some of the better performing, lower-risk alternatives with the same investment-grade style.”

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.

Solid Ideas for Rising Rates

The $480 million IGHG was up 0.2% this year, helped by a zero-duration portfolio, but one that was modestly different from LQDH. The ProShares ETF tracks a different FTSE Corporate Investment Grade index and had a lower 44% of assets in BBB rated bonds and more in higher-grade securities,” according to Rosenbluth.

LQDH seeks to mitigate the interest rate risk of a portfolio composed of U.S. dollar-denominated, investment-grade corporate bonds without being tied to an underlying index. The fund is the rate hedged answer to the iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSEArca: LQD).

Not only has LQDH outperformed LQD in the annualized three-year period, with its 4.0% total return, it has done so with lower volatility. LQDH’s three-year standard deviation of 3.83 was 12% below its older and larger sibling,” said Rosenbluth.

For more trends in fixed income, visit the Rising Rates Channel.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.