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An ETF That Hedges Inflation in a Rising Rate Environment

This article was originally published on ETFTrends.com.

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 (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.

Source: tradingeconomics.com

Source: tradingeconomics.com

"CPI is incorporated into portfolios specifically to provide a real return over inflation, without relying purely on duration," said Bruno. "Therefore, inflation is the primary driver of return and risk for the strategy. We see more conservative portions of the portfolio go to CPI compared to corporate bond or floating rate positions. We see cash being incorporated more into portfolios not for liquidity needs, but because investors do not find a suitable strategy that provides a real return over inflation without a significant reliance on duration."

The prevailing sentiment in the markets is that the Federal Reserve is set to increase interest rates for the rest of 2018, particularly when the S&P 500 is in the midst of the longest bull market ever. However, at some point, the jubilation in the record highs becomes overwrought exuberance and the markets will experience a correction or downturn--a scenario primed for investors to use CPI.

"If the market downturn happens in bonds, where there is an overreaction to rising rates, CPI would likely better provide a real return over inflation, as it is designed to do", said Bruno. "Equity market downturns tend to result in a risk-off flee to duration-based products such as corporate bonds, so if we are talking a typical equity sell-off; corporate bonds may fare well. We find that setting expectations is important with alternative strategies, because most tend to ask only about traditional risks like bond and equity sell-offs, when the question should be more around the intention of the position in a portfolio. For a real return over inflation that does not rely mostly on interest rate sensitivity (duration), CPI makes a lot of sense."

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