Whether you are a retiree or an investor accumulating for a goal, you probably have fixed income assets in your portfolio – at least you should. With the prospect of higher interest rates on the radar, investors need to consider bond ETFs to hedge interest rate risk.
Over the past several months yields on 10-year Treasuries have been ticking up. In the past month alone, this key benchmark rate has seen yields rise about 20 basis points. And whether you believe some Fed watchers who predict that the central bank will raise interest rates this September, the fact is that it’s a matter of when not if rates will rise.
For retirees who rely on interest income from their portfolios, it is all the more important to be prepared for the inevitable rise and the impact it will have on their income.
In some ways, investors may want to cheer the prospect of higher interest rates. Recent 10-year Treasuries touched 2.44%. Because of such low yields, investors have needed to look at other alternative sources of income-generating assets like dividend-paying stocks, convertible bonds, preferred stock and master limited partnerships. All of these have higher risk which may make many investors edgy especially as the current bull market is over six years old. (And as a parent of any six year old knows they can be prone to their own mood swings). In this case, a mood swing could be detrimental to stock prices.
While higher interest rates – if slowly and steadily increased allowing time to adjust portfolios – may be welcome as an indicator of economic expansion, there is also the prospect that such increases will negatively impact current bond portfolio values more quickly. This is because bond prices move inversely to prevailing market interest rates.
So one way bond investors may be able to help insulate their fixed-income portfolios is to use rate-hedged bond ETFs to generate income while protecting principal.
Investors and advisors may want to consider bond ETFs offered by ProShares or Deutsche Bank. ProShares High Yield Interest Rate Hedged ETF (BATS: HYHG) is comprised of long-positions in USD-denominated high yield corporate bonds (sometimes referred to as ‘junk bonds’) and short position in US Treasuries. The goal of the portfolio is to have an effective duration of zero.
Deutsche X-trackers High Yield Corporate Bond – Interest Rate Hedged ETF (NYSE Arca: HYIH) is a newer offering (start date 3/2015) and fewer assets (just $30 million as of 6/2015) that seeks to do the same thing using a similar zero duration strategy. The primary differences between these two ETFs is the underlying index used for tracking purposes.
Duration is the measure of a bond’s sensitivity to external interest rate changes. Think of it this way. If the market interest rates go up 1%, you’d like to know how will that impact your bond’s value. Because the price of the bond you hold moves in the opposite direction to interest rates, you would expect your bond’s price to drop when market rates go up. But by how much? That’s what the duration measure tells you.
And if duration is zero it means that the market’s changes in interest rates has no impact on your bond value.
There are certainly more established junk bond ETFs out there with more liquidity or lower expenses like SPDR Barclays Capital High Yield Bond ETF (JNK) or iShares iBoxx $ High Yield Corporate Bond ETF (HYG) but such funds only have long positions which will be impacted by interest rate increases.
Genearlly, an individual investor would be best advised to limit the total allocation to the High Yield space including such hedged ETF options to not more than 10% of a portfolio. All of this depends on individual circumstances.
Another option for trying to hedge the higher quality corporate bond portion of a portfolio is the ProShares Investment Grade Interest Rate Hedged ETF (IGHG). This option is designed to produce a low but not zero duration by combining investment-grade US and international bonds with short position sin US Treasuries.
In theory, such low and zero duration strategies should provide hedging options for a fixed-income portfolio. But potential investors need to be aware that these types of zero-duration or low-duration hedged bond ETFs may under-perform a non-hedged, long-only version of rates actually decline. These products are also relatively new (though the strategy is not).
Fixed-income investors may also want to consider using a dynamic portfolio approach as another way to hedge bond positions. In such an approach, assets are rotated from vulnerable areas to cash or other assets as indicated by various market indicators like trading volume, price level and measures of momentum.
Whatever an investor decides to choose should be done in conjunction with an overall income and investing plan. The time to prepare for a storm is when it’s sunny. So investors should prepare and research now or seek help from a qualified investment adviser.