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The Right Bond ETF For Fed Fun

ETF Professor

Earlier this week, the Federal Reserve raised interest rates for the third time this year, setting the stage for another rate hike of 25 basis points in December and perhaps several more increases in 2019.

Ongoing Fed tightening can also highlight the utility of fixed income exchange traded funds that hedge interest rate risk, including the iShares Interest Rate Hedged Corporate Bond ETF (NYSE: LQDH).

What Happened

The actively managed LQDH, which debuted nearly four and a half years ago, holds the iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSE: LQD) with positions in interest rate swaps used to establish the rate hedge. LQD the largest corporate bond ETF trading in the U.S.

“If you have a view that rates will rise across the yield curve but still want to hold corporate or emerging market bonds, an interest rate hedged ETF will allow you to express that view,” said BlackRock in a recent note. “These bonds might also offer more income than floating rate or short-maturity bonds, as they provide exposure to issues that are farther out on the yield curve. (Longer-maturity bonds typically yield more than their shorter counterparts.)”

LQDH's effective duration is 0.17 years compared to 8.39 years on the unhedged LQD.

Why It's Important

To gain the protection of hedging rate risk with an ETF like LQDH, investors typically sacrifice some income. LQDH's 30-day SEC yield is a solid 3.26 percent, but that's almost 80 basis points below the comparable metric on the unhedged LQD. In the right environment, rate hedged ETFs can make up for some of that income shortfall by outperforming unhedged strategies.

“Between May 2014 and February 2016, 10-year Treasury yields declined from 2.64% to 1.73%, according to Bloomberg; during that time, LQD outperformed its hedged version, LQDH,” said BlackRock. “ut when 10-year Treasury yields increased from 1.73% to 2.96% (through July 2018), LQDH outperformed, even accounting for the cost of hedging. It’s worth noting that over the past year ending 7/31/18, as 10-year Treasury yields increased 0.67% to 2.96%, LQDH did notably better. Performance will depend on the changes in both interest rates and credit spreads over the time period.”

What's Next

With the Fed poised to hike rates as many four times between now and the end of 2019, rate hedged strategies such as LQDH could continue garnering favor among fixed income investors.

LQDH has $242.62 million in assets under management of which $164.65 million has flowed into the fund this year.

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