Interest rate hedging: The must-know key to managing duration

Market Realist

Recommendation: Consider hedging against rising interest rates (Part 3 of 3)

(Continued from Part 2)

So how can an investor manage duration, beyond investing solely in short duration bonds? An alternative approach is to utilize interest rate hedging. An interest rate hedge utilizes a short position in a US Treasury future or similar security to seek reduced interest rate risk. A fully interest rate hedged investment would have a duration of 0. Such an investment can still provide yield and would primarily be subject to corporate default risk as that portion of the portfolio isn’t being hedged. Such an interest rate hedged investment could be used in combination with an unhedged investment to seek a targeted level of interest rate risk. It’s a spectrum, or radio dial of sorts, that could be used to target the right level of interest rate risk for an individual investor. For example, if we take the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD), we have a duration of 7.7 years. This duration may be a bit high for some investors, so to help reduce interest rate risk the fund could be combined with the iShares Interest Rate Hedged Corporate Bond ETF (LQDH), which has duration of zero. By combining the two, we could potentially have a duration of zero, a duration of 7.7, or anything in between, depending on an investor’s risk tolerance.

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Market Realist – The iShares  Interest Rate Hedged Corporate Bond ETF (LQDH) that Matt mentions above is an actively managed fund-of-funds. It takes a long position in the  iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD)  and shorts Treasury futures in order to achieve a net-zero portfolio duration. This bond strategy aims to capture the credit spread while eliminating interest rate risk.

The graph below compares the price performance  LQDH and LQD. LQD has essentially the same investment strategy as the  iShares Core U.S. Aggregate Bond ETF (AGG), which also tracks the total U.S. investment-grade bond market. 

Market Realist – Investors looking to invest in investment-grade corporate bonds could consider the Vanguard Total Bond Market ETF (BND) as an addition to their portfolios. BND gives you broader exposure to the overall bond market by including not only investment-grade corporate bonds (like AGG and LQD) but also Treasuries and municipal bonds.

LQD can be an effective hedge against rising interest rates. S ince LQD has only corporate bonds, its price reacts to changes in the credit spread. As the economy expands, credit spreads tend to narrow. This helps mitigate, to a certain extent, the hit to the price from rising interest rates.

To get further exposure to companies’ credit spreads, consider the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) and the SPDR Barclays High Yield Bond ETF (JNK). Both are below-investment-grade high yield corporate bonds with wider spreads. During economic expansion, they offer more scope for growth.

We could do something similar with the iShares iBoxx $ High Yield Corporate Bond ETF (HYG), a domestic high yield corporate bond ETF, which has a duration of 3.91 years. To potentially reduce this duration, we could combine HYG with the iShares Interest Rate Hedged High Yield Bond ETF (HYGH) which has a duration of 0.05 years.

The introduction of interest rate hedged ETFs gives investors another tool for managing interest rate risk. It joins short maturity funds, floating rate funds, and term maturity funds as ways for investors to customize the yield and duration of their fixed income portfolios. When we do begin to see interest rates rise, investors will have a full toolkit of fund options available to them.

The Interest Rate Hedged Funds are actively managed and do not seek to replicate the performance of a specified index. The Funds may have a higher portfolio turnover than funds that seek to replicate the performance of an index.

Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.

Securities with floating or variable interest rates may decline in value if their coupon rates do not keep pace with comparable market interest rates. The Fund’s income may decline when interest rates fall because most of the debt instruments held by the Fund will have floating or variable rates.

There is no guarantee that interest rate risk will be reduced or eliminated within the funds.

The Fund’s use of derivatives may reduce the Fund’s returns and/or increase volatility and subject the Fund to counterparty risk, which is the risk that the other party in the transaction will not fulfill its contractual obligation. The Fund could suffer losses related to its derivative positions because of a possible lack of liquidity in the secondary market and as a result of unanticipated market movements, which losses are potentially unlimited. There can be no assurance that the Fund’s hedging transactions will be effective. Investment in the Fund is subject to the risk of the underlying Funds.

Investing in long/short strategies presents the opportunity for significant losses, including the loss of your total investment. Such strategies have the potential for heightened volatility and in general, are not suitable for all investors.

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