The Federal Reserve raised interest rates in March, marking the third time in 15 months that the U.S. central bank has boosted borrowing costs. Supposedly, the March rate hike set the stage for more interest rate increases this year, but it is almost June, and the outlook for added rate hikes is muddled. Investors in search of income and those wagering that rates are on hold are flocking to fixed income exchange-traded funds (ETFs). Still, being prepared pays, and it must be noted that the Fed has not said that it will not raise rates again this year. While Fed speak can be confusing, investors can prepare for rising interest rates while maintaining fixed income exposure with interest rate hedged ETFs.
Interest rate hedged ETFs typically feature long positions in bonds and short positions in derivatives such as U.S. Treasury futures. Examples of interest rate hedged ETFs include the ProShares Investment Grade – Interest Rate Hedged (IGHG) and the iShares Interest Rate Hedged Corporate Bond ETF (LQDH). The iShares Interest Rate Hedged Corporate Bond ETF is the rate hedged answer to the popular iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD), the largest corporate bond ETF. (See also: Managing Interest Rate Risk.)
“Arguably, these ETFs could achieve the objective of reducing duration risk while maintaining credit exposure,” said Morningstar in a recent note. “Both funds have been around only for a few years, but they have been successful in hedging interest rate risk – maintaining a duration close to zero.” Duration measures a bond’s sensitivity to interest rate changes. LQDH has an effective duration of just 0.43 years compared with 8.26 years on the unhedged LQD. IGHG, the ProShares offering, has a scant net effective duration of 0.04 years. (See also: Advanced Bond Concepts: Duration.)
Seasoned fixed income investors are probably used to sacrificing yield to mitigate rate risk or incurring elevated credit risk to see increased income. That is not the case with IGHG and LQDH. IGHG has a 30-day SEC yield of 3.52 percent with an obviously low duration, and the bulk of the ETF’s holdings are rated between AA and BBB+. LQDH has a 30-day SEC yield of just over 3.1 percent, and over 93 percent of the ETF’s holdings are rated either AA, A or BBB+.
One issue with rate hedged ETFs is that some, including IGHG and LQDH, are highly correlated to equities, diminishing the diversification benefits often associated with mixing bonds and stocks in one portfolio. “While these funds do reduce interest rate risk, they tend to behave like stocks,” said Morningstar. “In fact, their monthly return correlation with the S&P 500 from June 2014 to March 2017 was 0.65. Investors tend to hold bonds to diversify equity, as bonds tend to go up when stocks go down, and vice versa.” (See also: Doves Turn Hawks: 5 Fed-Proof Bond ETFs to Buy.)