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ETF Strategies to Navigate Rising Rate Conditions

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This article was originally published on ETFTrends.com.

Fixed-income ETF investors should reexamine strategies for rising rates and consider some of the latest fixed income and specialized equity strategies designed for investing during a rising rate environment.

On the recent webcast (available On Demand for CE Credit), Rising Interest Rates and ETF Strategies to Manage Them, Simeon Hyman, Global Investment Strategist for ProShares, argued that yields may continue to rise and investors should be wary of the potential fallout in their traditional bond fund exposures if yields pick up pace. Specifically, yields on 10-year Treasuries have historically run about 2.5% above inflation. Consequently, if the Fed is targeting a 2% inflation rate, a "normal" 10-year yield should run around 4.5%.

"Rates could normalize without any change in the Fed Funds Rate. And if they did rise to normal levels, bond prices could take a big hit," Hyman said.

Hyman also contended that quantitative tightening could drive interest rate normalization, pointing to the end of quantitative easing as a key driver of interest rate normalization. For instance, the Fed is now letting $40B of its bond holdings mature every month without replacing them, rising to $50B this year. Consequently, investors may see a return to normalized fixed-income market trends where spreads tighten as interest rates rise.

Rising interest rates is of particular concern as many investors have looked to the Bloomberg Barclays Aggregate Bond Index as their go-to guide to fixed-income investments. However, the benchmark index is now exposed to greater duration risk and lower yields due to its high concentration in U.S. Treasuries and agency bonds.

Additionally, investors shouldn't forget about stocks either. Rising rates may negatively impact the equities market. Equity investors should note that sectors that have a high correlation to changes in rates have also changed over time, which may provide opportunities for targeted stock market selection that perform well during rising rate conditions.

"What’s interesting is that the sectors displaying the most positive correlation to rates changed over time, showing that sector movements with rates has been a dynamic and not a static process. While financials had a fairly low correlation in the first part of the data, it ultimately became much more sensitive to interest rates starting in 2011. And while consumer discretionary started the period fairly sensitive to rates, it became less so after 2013," Hyman said.

Minimizing Interest Rate Risk

Looking ahead when considering the fixed-income side of an investment portfolio, Kieran Kirwan, Director of Investment Strategy at ProShares, argued that minimizing interest rate risk is key when rates rise.

Specifically, Kirwan pointed to investment strategies like the ProShares Investment Grade-Interest Rate Hedged ETF (BATS: IGHG) and ProShares High Yield Interest Rate Hedged ETF (BATS: HYHG) that try to eliminate the rising rate risks.

"They maintain full exposure to credit risk as a primary source of return, while the built-in hedges are designed to alleviate the drag on returns caused by rising interest rates. Combined, these features change the drivers of risk and return, enabling HYHG and IGHG to target zero duration and zero interest rate risk," Kirwan said.

To achieve their zero duration, the rate hedged ETFs include exposure to U.S. Treasury futures across the yield curve that are shorted for an aggregate equivalent, but opposite, duration to the long portfolios. Due to their short Treasury exposure, the rate hedged investment strategies can be profitable when interest rates rise.

Kirwan advised investors that these rate hedged solutions may be used as replacements for short duration strategies, bank loans, or investment-grade floating rate strategies to diminish overall portfolio duration.

Additionally, Kirwan also suggested inverse bond ETFs as an additional way for fixed-income investors to hedge downside risks. For example, investors may look to something like the ProShares Short 20+ Year Treasury (TBF) , ProShares UltraShort 20+ Year Treasury (TBT) and ProShares UltraPro Short 20+ Year Treasury (TTT) .

Inverse bond ETFs are designed to move opposite a Treasury index or other bond market benchmark, but potential investors should be aware that the inverse strategies seek the opposite of the one-day return of a benchmark index. In trending periods, compounding can enhance returns due to the daily rebalancing, but in volatile periods compounding may hurt returns

By incorporating an inverse bond ETF to a fixed-income portfolio, investors can complement longer-term strategic moves, keep the majority of your portfolio's risk profile and income intact, and reduce bond risk without selling highly appreciated bonds, which may help avoid a taxable event.

On the equity side, investors may look to something like the ProShares Equities for Rising Rates ETF (EQRR) , the first U.S. stock ETF designed to outperform traditional large-cap indices, like the S&P 500, when interest rates rise. EQRR tries to reflect the performance of the Nasdaq U.S. Large-Cap Equities for Rising Rates Index, which selects 50 components from a universe of the 500 largest companies based on market capitalization listed on the U.S. exchange that have historically outperformed during periods of rising interest rates. The sector with the highest correlation will have a 30% position in the index, followed by 25% for the second highest, 20% for the third highest, 15% for the fourth highest and 10% for the fifth highest.

Financial advisors who are interested in learning more about alternative rising rate strategies can watch the webcast here on demand.