This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Clayton Fresk, CFA, portfolio management analyst at Georgia-based Stadion Money Management.
Interest rates are going to climb. It seems inevitable. However, the timing of when they will rise and the velocity with which they will rise is an issue of constant debate.
When rates finally do move higher, many fixed-income investors may be privy to price depreciation they have not experienced nor expected to experience from a “safe” asset class.
Based on recent issuance, it seems one of the ETF marketplace’s solutions to confront this price depreciation problem is interest-rate-hedged products. There is a plethora of them to choose from covering varying markets. What follows is my examination of 10 of these ETFs; their advantages and disadvantages; and other potential strategies an investor can use to protect against rising rates.
As of today, the high-yield market has the most interest-rate-hedged versions available, with five different issuers having products available:
- HYIH – Deutsche X-trackers High Yield Corporate Bond Interest Rate Hedged ETF (HYIY)
- HYGH – iShares Interest Rate Hedged High Yield Bond ETF (HYGH | C-44)
- THHY – Market Vectors Treasury-Hedged High Yield Bond ETF (THHY | F-45)
- HYHG – ProShares High Yield - Interest Rate Hedged ETF (HYHG | C-37)
- HYZD – WisdomTree BofA Merrill Lynch High Yield Bond Zero Duration Fund (HYZD | D-61)
While mostly attempting to offer similar exposures, each of these offerings varies slightly from one another, whether it is from the underlying index it tracks or the method to which each hedges the interest rate exposure.
The underlying index differentials are no different from any other ETFs that track different indexes, so I’ll focus briefly on the hedging mechanism/weights that each of the aforementioned uses. The following are the percentage of notional weights in the two-, five-, 10-year or long bond futures (as of April 10 holdings):
|2 Year||5 Year||10 Year||Long Bond|
I should note that HYZD tracks a short-duration high-yield index, so the makeup of its hedge will naturally be different from the others, all of which track broad high-yield indexes.
THHY is different from its competitors in that it uses only five-year Treasury futures, whereas the others use futures across the curve. But among the other three, while the futures used are the same, the weightings are different. While, on its face, these weights are not massively different, they can be a source of performance differential between the names based on the shape of the yield curve during a potential rate increase.
There are currently three interest-rate-hedged offerings in the investment-grade corporate space:
- IGIH – Deutsche X-trackers Investment Grade Bond - Interest Rate Hedged ETF (IGIH)
- LQDH – iShares Interest Rate Hedged Corporate Bond ETF (LQDH | C-32)
- IGHG – ProShares Investment Grade - Interest Rate Hedged ETF (IGHG | B)
Similar to the high-yield names, each of these ETFs has slightly different hedging weights in place:
|2 Year||5 Year||10 Year||Long Bond||Long Bond|
There is a bit more dispersion in the futures and weights used to hedge on the investment-grade side as compared to the high-yield side. For example, IGHG focuses on hedges more via the long end of the curve, whereas LQDH uses more short-end exposure. Once again, this could be a cause of performance differential between the names depending on how the yield curve moves in a rate rise.
There are a few other market segments currently covered by interest-rate hedged products. The Barclays Capital U.S. Aggregate Bond Index is covered by the WisdomTree Barclays U.S. Aggregate Bond Zero Duration fund (AGZD | B-41).
Lastly, interest-rate-hedged emerging market exposure can be obtained via the Deutsche X-trackers Emerging Markets Bond - Interest Rate Hedged ETF (EMIH). While this is currently the only emerging-market-focused product available, it appears a few other ETF issuers have similar products in registration.
This seems to be a logical move, as all the “spread product” pockets of fixed income have seen a proliferation of products come to market. Also, the dollar-denominated emerging market exposure has a bit longer duration profile as compared with high yield, so hedging may be of more importance in this market when interest rates climb.
For those who desire to hedge against rising rates, these products seem to make sense in that they are a “one-stop shop.”
Many clients may not have the ability to hold futures, so having that exposure embedded into the ETF itself versus being an external investment is an attractive feature. Another positive is these products allow for a reduced duration without having to slide exposure down to the short end of the Treasury curve, or into floating-rate products or other alternative exposures, such as bank loans.
A disadvantage to these hedged products is that if rates were to continue to decrease, an investor would not capture the price appreciation that the unhedged ETFs would. For example, on a year-to-date view, the hedged HYGH has returned 1.8 percent as compared with 3.2 percent for the unhedged iShares iBoxx $ High Yield Corporate Bond ETF (HYG | B-64). The key variable there was a 0.25 percent decline in the five-year Treasury yield.
Another disadvantage to these products, at least initially, seems to be a lack of market acceptance.
The combined assets of the 10 ETFs I’ve identified are only $480 million. Also, liquidity is an issue, with the average 20-day trading volume (notional) being only a bit above $4 million. Further, a majority of both the assets and volume are in just two of those products: HYHG and IGHG.
That said, the Deutsche Bank products only came to market in March 2015, so they may just need more time to capture market share.
There have been numerous interest-rate-hedged products brought to market over the past few years. While these products make sense in terms of protecting against rising rates, the market has been slow to accept them. Whether this is an ongoing concern or more a function of an unfavorable market—as in rates continue to decline, not increase—is yet to be determined.
At the time this article was written, certain Stadion portfolios held long positions in HYG.
Founded in 1993, Stadion Money Management is a privately owned money management firm based near Athens, Georgia. Via its unique approach and suite of nontraditional strategies with a defensive bias, Stadion seeks to help investors—through advisors or retirement plans—protect and grow their “serious money.” Contact Stadion at 800-222-7636 or www.stadionmoney.com. References to specific securities or market indexes are not intended as specific investment advice.