A rising interest rate environment will weigh on fixed-income portfolios. Bond traders do not need to sacrifice yield-generation to diminish rate risk. Instead, investors can look to rate-hedged or zero-duration bond exchange traded funds.
A relatively new breed of interest rate-hedged, zero duration ETFs hold long-term bonds, but they will simultaneously short Treasuries or Treasury futures contracts to hedge against potential losses if interest rates rise – bond prices have an inverse relationship to interest rates, so rising rates corresponds with falling bond prices.
Unlike traditional bond ETFs, the rate-hedged bond ETFs try to mitigate the negative effects of a rising rate environment through shorting Treasury futures to match the overall duration of their diversified bond holdings. Looking further out, these types of hedged-bond ETFs could provide suitable exposure to the fixed-income market in a rising interest environment, especially as the Federal Reserve plans on hiking rates sometime later this year.
The long/short bond ETFs can provide an alternative means to invest in fixed-income assets without sacrificing yields while diminishing the negative effects of rising rates on a bond fund’s price. Specifically, due to their near-zero durations, the bond funds should show little sensitivity to changes in interest rates.
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For example, the popular investment-grade corporate bond ETF, iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) , has a 8.32 year effective duration and a 3.19% 30-day SEC yield, so a 1% increase in interest rates could translate to a 8.32% decline in the ETF’s price. Consequently, many have shifted down the yield curve to lower duration bond ETFs as a means to hedge against rising interest rates – a lower duration means that the fund would be less sensitive and exhibit a lower decline in the event of rising interest rates.
Alternatively, something like the iShares Interest Rate Hedged Corporate Bond ETF (LQDH) holds short positions in interest rate swaps, which provides the rate-hedged ETF with a 0.03 effective duration – a 1% rise in interest rates would translate to a 0.03% decline in the funds price, and LQDH would still offer up a 3.43% 30-day SEC yield.
Investors who are interested in the rate-hedged bond strategy have a number of ETF options available.
Interest Rate-Hedged ETFs:
- Deutsche X-trackers Investment Grade Bond – Interest Rate Hedged ETF (IGIH)
- Deutsche X-trackers High Yield Corporate Bond – Interest Rate Hedged ETF(HYIH)
- Deutsche X-trackers Emerging Markets Bond – Interest Rate Hedged ETF (EMIH)
- iShares Interest Rate Hedged Corporate Bond ETF (LQDH)
- iShares Interest Rate Hedged Emerging Markets Bond ETF (EMBH)
- iShares Interest Rate Hedged 10+ Year Credit Bond ETF (CLYH)
- iShares Interest Rate Hedged High Yield Bond ETF (HYGH)
- Market Vectors Treasury-Hedged High Yield Bond ETF (THHY)
- ProShares Investment Grade-Interest Rate Hedged ETF (IGHG)
- ProShares High Yield Interest Rate Hedged ETF (HYHG)
- WisdomTree Barclays U.S. Aggregate Bond Zero Duration Fund (AGZD)
- WisdomTree Barclays U.S. Aggregate Bond Negative Duration Fund (AGND)
- WisdomTree BofA Merrill Lynch High Yield Bond Zero Duration Fund (HYZD)
- WisdomTree BofA Merrill Lynch High Yield Bond Negative Duration Fund (HYND)