Hedge Duration With Fixed-Income ETFs
Investors looking to manage their duration risk for themselves have a new tool in hedged fixed-income ETFs: a hybrid product combining a long basket of bonds coupled with a short position in Treasury futures.
In case of a rising-interest-rate environment, the short position hedges the bond losses, mitigating interest-rate risk while capturing credit spread. We can easily understand how this structure would appeal to the investor worried by rising rates but still looking for yield. The first hedged-interest ETF in U.S. markets, the Market Vectors Treasury-Hedged High Yield Bond ETF (THHY | D-51), was launched in March 2013. As of October 2014, their number of products has increased to nine. They have collectively amassed over $450 million in assets (Figure 2).
Investors need to take into consideration that hedged ETFs may not cover complete duration risk due to the convexity of the yield curve. Immunization strategies around these products would result in significant trading costs. Ultimately, investors forgo some yield due to the hedge protection, and in stable range-bound markets, the hedge would act as a drag to the total return.
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Another tool for investors to protect them from rising interest rates is “floater ETFs.” Their underlying securities are floating-rate notes that reset their coupon payments periodically. Thus, interest-rate risk is greatly reduced.
They may hold securities rated BBB-, which are on the borderline of the investment-grade space to increase yields.
However, investors need to be aware that some of the underlying securities are highly illiquid. FLOT is the biggest fund, with $4.1 billion in AUM. Its higher size and daily average volume make it more liquid and provide lower spreads than its competitors. But not all floater ETFs have been successful.
ETFs such as the WisdomTree Bloomberg Floating Rate Treasury ETF (USFR) and the iShares Treasury Floating Rate Fund (TFLO) provide investors low-risk vehicles to capital preservation. Yet with minimal risk comes minimal returns. So far, they’ve been shunned by investors, with AUM of $2.5 million and $10 million, respectively.
While the current interest-rate environment may not be ideal for these Treasury floaters, at the moment, products with higher credit exposure and hence higher yields are investors’ favorites.
Not to be unnoticed, higher interest rates may affect the credit quality of the underlying issuers due to higher coupon payments, and they create larger losses than in other sectors.
Even more, the underlying securities can be illiquid, and in some cases, the indexes may be hard to replicate. While funds like FLOT have decent daily volume, other funds have higher market spreads that increase transaction costs. Floaters may have different durations risk depending on their reset periodicity, and that risk is at its highest right after the coupon payment reset date.