Interest Rate Hedged ETFS Are a Good Bet

Bonds and interest rates are not the best of friends. In fact, they run away from each other and have an inverse relationship. When rates rise, bond prices fall. The reason is that newly issued bonds coming to market will have higher coupons based on the current benchmark rate. For those bonds already on the market, investors will reprice them accordingly to match the current rate of the newly issued bonds. So, if you own a 10-yr Treasury that yields 2% and a new 10-yr Treasury bond that now pays 4%, the price of your bond will fall enough to match the 4% yield.

There’s another factor that goes along with this inverse relationship. and it’s called a bond’s duration.

Duration is basically a measurement of a bond’s interest rate risk that also considers factors like a bond’s maturity, yield, coupon and call features. Duration can be used to figure out just how much a bond will fall when rates rise.

For example, if the Fed raises rates by 1%, a bond with a 5-year average duration would see its price drop by 5%. A 30-year bond would see a 30% price decline, which helps explain why the Bloomberg US Aggregate Bond Index lost nearly 13% last year – the worst return for bonds in over 250 years. The Fed went from essentially 0 to over 4.25% in such a short time.

For investors buying and holding a bond until it matures, rates and duration isn’t a big deal. After all, you’ll get your principal back when the bond matures. However, for the bulk of investors, duration is a problem. Most of us don’t buy individual bonds, we get our exposure through bond mutual funds, or ETFs. And because of their mandates, bond funds are constantly buying new bonds at these different rates. Therefore, they are locking in losses.

But there are some tools we can use to help reduce our duration risk and limit the potential problems with our bond portfolios. And one of them comes from an institutional investor’s tool box – using derivatives.

Derivatives, swaps and other options can be used by investors to hedge away the risks in a variety of asset classes, including bonds. In the case of bonds, interest rate swaps can come handy as they trade one stream of future interest payments for another while so-called plain vanilla swaps allow an investor to pay out a fixed rate of interest and then receive floating payments based on interest rates. Likewise, derivatives that short Treasury bonds help produce profits when prices fall and rates rise.

Ultimately, all of these moves push the duration risk onto someone else and reduce the effects of rising rates on a bond portfolio.

The problem is that all of this is very confusing and somewhat difficult to do for the average Joe. It takes a lot of knowledge to hedge a bond portfolio with swaps and options. But luckily, the ETF boom has created some easy-to-purchase options designed to hedge away duration risk.

These funds either buy derivatives to hedge away the risk or create a portfolio of long/short bonds to reduce losses, essentially doing the heavy lifting for you. And with many of them, they can reduce duration significantly while still maintaining a high yield. Interest risk is removed, while credit risk remains. And they do so, for lower expenses than you or I could do on our own.

And the proof is in the pudding. For example, the ProShares High Yield—Interest Rate Hedged ETF (HYHG), which owns junk bonds while hedging duration, only fell by 1.69% last year. The investment grade-focused iShares Interest Rate Hedged Corporate Bond ETF (LQDH) only dipped by 1.33%. That’s far better than its respective sector average last year. Better still, both offer compelling yields of 8.04% and 3.21%, respectively: in line with their sector averages.

Now, interest rate hedged ETFs aren’t a panacea. As rates fall, returns for the funds would be less than their non-hedged counterparts. But given the Fed’s continued stance and outlook about the pace of hikes still going up, they could make for a good bet.

And with funds available from many top ETF providers that cover most segments of the bond market, including the benchmark aggregate bond index, it pays to add some exposure to a hedged ETf for the current environment. It could save your portfolio from losses and still offer plenty of income.

Take a look at our recently launched Model Portfolios to see how you can rebalance your portfolio.