ProShares: The Shortcomings Of Short Term Bond Funds

June 12, 2017

[This ETF Industry Perspective is sponsored by ProShares.]

Bond prices fall when interest rates rise. So when interest rates are trending up, many investors shift their fixed-income holdings to short-term bonds in order to reduce interest rate risk. What they may not realize is that, by doing so, they shortchange their potential returns in two ways:

  • First, moving to short-term bonds reduces interest rate risk but it doesn’t eliminate it. Short-term bonds still have rate risk.
  • Second, short-term bonds have less exposure to credit opportunities (and of course, risk), a key driver of bond returns.

An alternative approach is to seek to eliminate interest rate risk while maintaining full exposure to credit opportunities. This is what an interest-rate-hedged strategy aims to do. It’s important because, when rates rise, credit spreads have typically tightened and boosted returns.

An Interest-Rate-Hedged Strategy Maintains Full Exposure to Credit Risk/Opportunity

A Better Way To Prepare?

The ProShares Investment Grade—Interest Rate Hedged (IGHG) tracks the Citi Corporate Investment Grade (Treasury Rate-Hedged) Index, which offers a diversified portfolio of investment-grade long-term bonds with a built-in interest rate hedge. IGHG maintains full exposure to credit risk as a primary source of return, while the hedge is designed to alleviate the impact of rising rates.

The Takeaway

Short-term bond funds help investors reduce their interest rate risk, but they have shortcomings. If you’re looking for a potentially better solution for rising rates, consider an interest-rate-hedged bond ETF like IGHG.

When Interest Rates Rose, IGHG's Index Outperformed a Short-Duration Bond Index

Source: Bloomberg, December 2013–March 2017. Average performance based on quarterly changes in the 10-year Treasury yield. Rising rate periods are any calendar quarter where the 10-year Treasury yield increased. As of 3/31/17, the duration of the Citi Corporate Investment Grade (Treasury-Rate Hedged) Index was 10.18 years. Duration is a measure of a fund’s sensitivity to interest rate changes, reflecting the likely change in bond prices given a small change in yields. Higher duration generally means greater sensitivity. The Bloomberg Barclays U.S. 1–5 Year Corporate Bond Index measures the investment return of U.S. dollar denominated, investment-grade, fixed rate, taxable securities issued by industrial, utility and financial companies with maturities between 1 and 5 years.

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