Using ETFs To Hedge Against Rising Rates

September 29, 2016

The September Federal Reserve meeting passed without much fanfare, quieting markets that had been getting jittery about a rate hike. The central bank―eyeing the uncertainty of a presidential election in November―chose to delay its much-anticipated interest rate increase, but not for long.

After the no-change decision, Federal Reserve Board Chair Janet Yellen told the press that she expects a rate hike sometime this year. That means that an increase may come either at the November or December meeting, with most economists targeting the latter as the likeliest option for a move.

If so, it will be deja vu, for it was last December when the Fed hiked rates for the first time in nearly a decade after months of anticipation. Another hike this December would push the federal funds rate up by 25 basis points to a range of 0.50-0.75% from 0.25-0.50%.

Rates Down From Start Of Year

Market-set rates are up from their lows ahead of the potential rate increase, though they're down significantly from where they were at the start of the year.

The two-year Treasury bond yield, for example, is at 0.75%, up from a low of 0.50% in June, but down from 1.05% on Dec. 31. At the same time, the 10-year Treasury bond yield is at 1.56%, up from a record-low 1.32% in July, but down from 2.27% on Dec. 31.

It's impossible to say whether the next Fed hike will be the catalyst that finally spurs a big rally in interest rates (and sell-off in bonds). But for investors who want to protect themselves, there are many tools available in the ETF world to minimize the impact of higher rates, or even capitalize on them.

Lower Duration Bonds

The classic advice given to investors in a rising rate environment is to reduce the duration of your bond portfolio. Duration is a measure of interest rate risk and is based on a bond's maturity and coupon payments.

A higher-duration portfolio has more interest rate risk than a lower-duration portfolio. By reducing duration―for example, by buying shorter-term bonds―a portfolio will have less interest rate risk. The flip side is that the portfolio will probably have a smaller yield as well.

There are plenty of low-duration ETFs on the market that can help reduce the average duration of an investor's portfolio, including the iShares 1-3 Year Treasury Bond ETF (SHY), the PIMCO Enhanced Short Maturity Active ETF (MINT) and many more.

Inverse Bond ETFs

Another method with which to hedge against rising rates is inverse ETFs. These funds short Treasury bonds, meaning they rise in price when interest rates increase (bond prices and rates generally move inversely).

The ProShares Short 20+ Year Treasury ETF (TBF) provides daily inverse exposure to Treasurys with maturities greater than 20 years.

Meanwhile, the Sit Rising Rate ETF (RISE) shorts futures contracts on two-, five- and 10-year Treasurys with a specific goal of maintaining a duration of negative 10. That means if interest rate rise by 1%, the ETF should rise by 10% (and vice versa).

TBF, RISE and similar ETFs can be used to hedge other bond funds in a portfolio or as stand-alone products to speculate on the direction of interest rates.

Keep in mind, however, that any product that shorts positive-yielding bonds will have to pay a cost to maintain that position over time. This can result in losses even if interest rates remain flat.

YTD Returns For TBF, RISE, TLT, IEF

 

 

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