How to Hedge Your Fixed Income Exposure | ETF Trends

By Jamie Viceconte, CIO and Chief Marketing Officer, FolioBeyond

You may be more exposed to higher interest rates than you think, and here is a potential way to fix it.

Many investors hold fixed income securities in their portfolios. After all, the much-maligned “60/40” rule still defines a standard for both retail and institutional portfolios, even if it isn’t as strictly adhered to as it once was.

Given the uncertainties about the interest rate outlook, it seems prudent to quantify how much interest rate risk exists in a typical portfolio and what investors and advisors can do to help manage that risk.

If we use the Bloomberg US Aggregate Bond Index (“Agg”) as a benchmark for diversified fixed income portfolios, we can get a rough sense of the extent of the exposure for a broad class of investors. The Agg has a “duration” of about 6.7 years. [1]  Consequently, for a 1% increase in interest rates, Agg investors would see a roughly 6.7% drop in the value of that position. A 2% rise in interest rates would lead to an approximately 13.4% drop in value. These potential moves in value are significant, yet similar changes in interest rates have historically happened relatively quickly.[2]

Prior to 2013, the duration of the Agg was less than 4.5 years. Over the following 5 years through 2017 the average duration trended to over 5.5 years. The magnitude of expected changes in value at different duration measures on the Agg arising from an immediate interest rate shock is presented below:

Change in value of the Agg Arising From an Immediate Rate Shock

Duration -50 bps +50 bps +100 bps +200 bps
4.5 +2.25% -2.25% -4.50% -9.00%
5.5 +2.75% -2.75% -5.50% -11.00%
6.5 +3.25% -3.25% -6.50% -13.00%
7.0 +3.50% -3.50% -7.00% -14.00%

For illustrative purposes only and does not represent or predict the performance of a strategy. The duration of the Agg is multiplied by the rate shock to determine the immediate change in value of the Agg (Duration*bps). bps = basis points, 1 basis point = 0.01%.

Given the extension in duration in the Agg, utilizing a product with an offsetting “negative duration” can dramatically reduce that increased interest rate exposure. For example, mortgage-backed security interest-only strips (“MBS IOs”) have a negative duration, meaning that they tend to increase in value as interest rates rise. MBS IOs are coupon payments de-bundled from fixed-rate mortgage-backed securities, typically issued by the US Agencies of FNMA, FHLMC and GNMA. Using MBS IOs in combination with US Treasury securities (“USTs”), an investor can create an exposure with a duration of roughly negative 10 years.

By replacing Agg exposure with some proportion of MBS IOs and USTs, the duration of the overall portfolio can be reduced to historical duration of the Agg of 4.5 to 5.5 years.

And the cost of reducing exposure to the Agg index is de minimus because a sample portfolio of MBS IOs and USTs has roughly the same current 2% yield as the Agg.

[1] Duration is a measure of interest rate sensitivity for a security or portfolio and, roughly speaking, measures the extent to which the value of a security or portfolio declines in the event of a 1% increase in interest rates. There are nuances to that, but it is sufficient for our purposes here. Source: Bloomberg.

[2] Since 1981, there have been 34 instances where long-term interest rates have increased by more than 100 bps in 9 months or less. Source: Bloomberg.

For investors who want to add an allocation of MBS IOs and USTs to their portfolio, there’s the FolioBeyond Rising Rates ETF (“RISR”). You can find the prospectus here. RISR is an active ETF that seeks to protect against rising rates while generating current income when rates remain stable. RISR does this by holding MBS IOs, which it does in combination with USTs, to achieve an overall target duration for the fund of negative 10 years.

Important Information

Investors should consider the investment objectives, risks, charges and expenses carefully before investing. For a prospectus or summary prospectus with this and other information about the Fund, please call (866) 497-4963 or visit our website at Read the prospectus or summary prospectus carefully before investing.

Investments involve risk. Principal loss is possible. Unlike mutual funds, ETFs may trade at a premium or discount to their net asset value. The fund is new and has limited operating history to judge.

Fund RisksThe value of MBS IOs is more volatile than other types of mortgage-related securities. They are very sensitive not only to declining interest rates, but also to the rate of prepayments. MBS IOs involve the risk that borrowers may default on their mortgage obligations or the guarantees underlying the mortgage-backed securities will default or otherwise fail and that, during periods of falling interest rates, mortgage-backed securities will be called or prepaid, which may result in the Fund having to reinvest proceeds in other investments at a lower interest rate. The Fund’s derivative investments have risks, including the imperfect correlation between the value of such instruments and the underlying assets or index; the loss of principal, including the potential loss of amounts greater than the initial amount invested in the derivative instrument. The value of the Fund’s investments in fixed income securities (not including MBS IOs) will fluctuate with changes in interest rates. Typically, a rise in interest rates causes a decline in the value of fixed income securities owned indirectly by the Fund. Please see the prospectus for a complete description of principal risks.

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