With interest rates jumping to a one-year high off of historic lows, bond exchange traded fund investors may be interested in rate-hedged fixed income strategies to mitigate rate risks ahead.

Specifically, the ProShares Investment Grade-Interest Rate Hedged ETF (Cboe: IGHG) and ProShares High Yield Interest Rate Hedged ETF (Cboe: HYHG) are two rate-hedged ETF strategies that try to eliminate the risk of rising interest rates. The two 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.

Consequently, these rate-hedged bond ETFs do not have to sacrifice their attractive yields when limiting their sensitivity to rising rates, allowing investors to still generate income without having to move down the yield curve. By hedging away rate risk, bond investors can focus on the underlying debt securities without fear of the negative effects of rising interest rates, maintain their current level of income generation, and potentially capitalize on the tightening credit spreads.

ETF Trends recently caught up with Simeon Hyman, Global Investment Strategist, ProShares, to discuss developments in the bond market, notably the sudden spike in interest rates.

ETF Trends: Interest rates have been on the rise. How far do you think they can go?

Hyman: The long-term average 10-year US Treasury yield has been around 4 percent, reflecting around 2 percent inflation and 2 percent real yield. Rising inflation could push yields higher, but real yields, which are still negative across much of the treasury curve, could rise as well. Still, a somewhat vigilant Fed makes a 4% 10-year yield unlikely until quite far off into the future. But 2.5% may not be, and that’s a key consideration for investors as they build fixed income portfolios.

ETF Trends: HYHG and IGHG are interest-rate hedged ETFs – what does that mean?

Hyman: When interest rates rise, bond prices fall, and the value of a typical bond fund investment declines. Longer-term bonds generally have more exposure to rising rates than shorter-term bonds. But even short-term bonds often still have some exposure to rising rates. IGHG and HYHG are interest rate-hedged bond funds. They offer a diversified bond portfolio that includes a built-in hedge designed to eliminate interest rate risk.

ETF Trends: So what’s good about corporate bonds when interest rates rise?

Hyman: It is often an improving economy that drives interest rates higher, which can coincidentally lead to a tightening of credit spreads. And thus, historically speaking, when interest rates have risen, credit spreads have tightened. The combination of a long portfolio of corporate bonds (investment grade for IGHG, and high-yield for HYHG) with a hedge to protect from rising interest rates can be a particularly effective formula. The ETFs benefit from tightening spreads which can push corporate bond prices up, while the hedge protects from the negative impact of rising rates.

ETF Trends: Can you speak to the sector makeup of the funds?

Hyman: IGHG and HYHG’s bond portfolios are designed to reflect the composition of the broad investment grade and high-yield markets, respectively. The investment grade corporate bond market, and thus IGHG, have a substantial allocation to the financial sector. The high-yield corporate bond market, and thus HYHG, have a substantial allocation to Industrials. Both of these sectors have historically responded well to rising interest rates and economic expansion—many observers have noted Financials and Industrials may be important beneficiaries of the recovery—and have been likely contributors to the beneficial tightening of spreads in rising rate environments.

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