An ETF That Hedges Inflation in a Rising Rate Environment

For ETF investors, floating rate corporate bond ETFs provide the necessary hedge against a rising rate environment, but what are the options when inflation is rising in conjunction with the federal funds rate? Rising inflation can tamp down any returns realized from floating rate corporate bonds, but investors are keen to look at the IQ Real Return ETF (NYSEArca: CPI) as an option to hedge against inflation.

CPI seeks investment results that correspond to the IQ Real Return Index–a “fund of funds” that invests its net assets in the investments incorporated within the underlying index. Fixed-income investors using corporate bond ETFs are subject to duration risk tied to interest rates, but in an economic environment where inflation is also rising, an ETF like CPI would be of benefit.

Furthermore, corporate bond ETFs that invest in debt issues featuring a floating rate component are also subject to credit risk as the bonds are typically tied to companies that are below investment-grade. This poses a risk to investors, particularly since companies tied to below investment-grade debt have a higher propensity to default.

“Corporate bond ETFs tend to have a very significant tie to duration risk with performance expectations more tied to interest rates and credit spreads rather than inflation,” said Salvatore Bruno, Chief Investment Officer of IndexIQ. “Floating rate may be incorporated into portfolios where rising rates are a concern; providing an increasing coupon as rates rise to offset the see-saw effect bonds have with interest rates. However, floating rate bonds have no specific tie to inflation. They are typically issued by companies that are below investment grade, and therefore can experience significant credit risk. Often, floating rate bond positions are used as a way to dampen duration sensitivity of corporate bonds but they largely retain credit risk meaning they could suffer if credit spreads widen or defaults rise.”

Based on the graphs below, the inflation rate and federal funds rate have been in lockstep–an upward trajectory. Investors can use CPI in conjunction with floating rate corporate bond ETFs in their portfolios to capitalize on the rises seen in both within the past year.