Higher Interest Rates? There’s An ETF For That

The not so inside joke about the exchange-traded fund marketplace is that there’s an ETF for whatever financial concerns you or your clients may have. Joking aside, today’s climate of rising interest rates has many fixed-income investors on edge, putting rate-hedged funds into the spotlight.

While bond yields are high enough to offer a relatively attractive alternative to stocks, many investors are still avoiding bonds in anticipation of even higher interest rates in the future. Is there a way to capture current bond yields without suffering losses if rates continue heading up? Rate-hedged ETFs have an offer they hope you won’t refuse.

The general idea behind ETFs with rate-hedging strategies is to own a basket of corporate bonds while simultaneously short selling U.S. Treasuries with identical maturities. By design, any losses realized by the corporate bonds due to higher interest rates would be offset by gains from selling Treasuries short. Has it worked?

Let’s compare the recent performance of the iShares Interest Rate Hedged Corporate Bond ETF (LQDH) against its unhedged cousin, the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD). Beginning when 10-year Treasuries hit their low of 1.37 percent on July 8, 2016 up until the current yield now near 2.98 percent, the unhedged corporate bond ETF (LQD) has declined 0.45 percent. Meanwhile, the rate-hedged version (LQDH) has gained 11.20 percent during the same period. Not a bad return, especially after 10-year rates more than doubled.

A similar pattern of outperformance has been experienced in other segments within the broader bond market. Using the same July 8, 2016 starting point up until present, the ProShares High Yield—Interest Rate Hedged ETF (HYHG) has jumped 20.42 percent while the unhedged SPDR Bloomberg Barclays High Yield Bond ETF (JNK) has gained 13.76 percent.

Protecting against the threat of higher rates via ETFs is still a fairly new idea that didn’t exist five years ago. While these types of ETFs aim to mute the negative impact of higher rates, they aren’t a cure-all.

During periods of falling rates, for example, a rate-hedged strategy is likely to perform worse versus an unhedged strategy. The hedged LQDH fund, for example, lost 9.61 percent from its inception date on May 27, 2014 through mid-February 2016 as the yield on 10-year Treasuries sharply declined.

Also keep in mind that rate-hedged funds do not hedge against or eliminate credit risk because they still maintain constant exposure to a basket of bonds. So if bond issuers default or go bust, performance returns would likely suffer. This is particularly true of ETFs linked to high-yield or junk bonds that carry elevated credit risk.

Finally, there are other ways to hedge against the danger of higher interest rates. Laddering bonds with sequentially longer maturity dates is still a more commonplace strategy among fixed-income investors. If interest rates go up, investors are able to redeploy the money from maturing bonds into new ones with higher yields. This strategy can be accomplished with target-maturity bond ETFs that deliver an expected cash payout date while providing diversification across a spectrum of different bonds.

Like any investment, rate-hedged ETFs have caveats. Nevertheless, they’ve mostly delivered as advertised during their brief history. And for many bond investors seeking protection, an imperfect hedge is better than none.

Ron DeLegge is founder and chief portfolio strategist at ETFguide.