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ETFs to Deconstruct the AGG and Hedge Currency

This article was originally published on ETFTrends.com.

The iShares Core US Aggregate Bond ETF (AGG) tracks the investment results found in the Bloomberg Barclays U.S. Aggregate Bond Index, which can give fixed income investors broad exposure to the bond markets.

However, there are times when higher yields can be extrapolated from deconstructing the AGG, particularly in a current economic climate that warrants a spike in interest rates.

Companies like WisdomTree Investments offer exchange-traded funds that capitalize on the strategy of deconstructing the AGG, which pertains to an investment strategy that corners a specific portion of the bond market sectors–government debt via Treasuries, agencies, credit, mortgage-backed securities (MBS), commercial mortgage-backed securities (CMBS), and asset-backed securities (ABS).

"We believe deconstructing and reassembling the AGG can be done systematically to deliver competitive performance and create investment exposures that better align with investor objectives," Rick Harper, Head of Fixed Income at WisdomTree Investments, told ETFTrends.com. "Thoughtful yield enhancement through enhanced strategies and risk mitigation through interest rate hedged strategies are just two ways in which packaged solutions can be incorporated into investor portfolios in performing against the AGG."

Related: Bond Markets Watching How Trade Disputes Impact Rates

Deconstructing the AGG allows exposure to various sectors of the bond market where yields are higher, but it may come with an investor's willingness to accept more risk. WisdomTree has two ETFs using the deconstruction strategy-- WisdomTree Yield Enhanced U.S. Aggregate Bond Fund (AGGY) and WisdomTree Yield Enhanced U.S. Short-Term Aggregate Bond Fund (SHAG) --to focus on a specific segment of the bond market, especially when short-term rate movements make their impact felt.

"Interest rate sensitivity is a significant driver of returns for core fixed income strategies and various investment strategies have been developed to give investors greater control over this risk," said Harper.

Deconstructing the AGG can be a case of auspicious timing if implemented now, particularly when current Treasury yields have been relatively flat. As such, AGG has been on a downtrending path the past 12 months.

ETFs to Deconstruct the AGG and Hedge Currency 1

"Since Treasuries constitute roughly 37% of the Aggregate, the rise in Treasury rates (and interest rates in general) has negatively impacted the performance of the Aggregate in recent years," said Harper. "Spread tightening has, however, provided some offset return erosion from rising rates. The overweight to more credit intensive sectors has enabled the Aggregate Enhanced Yield to outperform the Aggregate since its inception in 2015."

Currency Hedging Strategies

With the Federal Reserve's recent rate hike of the federal funds rate from 1.75 to 2, the dollar index has also been gaining year-to-date, particularly since the middle of April. While this bodes well for investors who are long on the greenback, it's not-so-good news for investors long on other currencies against the dollar.

ETFs to Deconstruct the AGG and Hedge Currency 2

Case in point--the euro has seen better days as evidenced in the chart below. The euro has been down about 6.4 percent since touching a high in February.

ETFs to Deconstruct the AGG and Hedge Currency 3

"The moves in the euro this year remind investors that the currency is not always a one-way trade higher," Jeremy Schwartz, WisdomTree Director of Research told ETFTrends.com.

In the case of investing in the Eurozone, Schwartz recommends a currency hedging strategy using ETFs, such as the  WisdomTree Europe Hedged Equity Fund (HEDJ) or for broad-based international exposure, the WisdomTree International Hedged Quality Dividend Growth Fund (IHDG) . HEDJ is up 1.53 percent year-to-date and IHDG has provided an 8.61 percent return the last three years.

There is a lingering school of thought that currency exposure may be an expensive option, but with more interest rate hikes looming as the Federal Reserve exhibits more hawkishness, the returns that can be derived could outweigh the costs.

Related: The Short End of it With an Active Bond ETF

"Many also have thought currency hedging can be an 'expensive proposition' but as the Federal Reserve has been hiking interest rates at much faster pace than global central banks, one can be paid an increasing amount of net interest rates to neutralize their currency exposure and is now over 2% per year against the euro and yen with this amount set to rise over coming quarters," said Schwartz.

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