How A Negative-Duration Bond ETF Works

January 14, 2014

Institutional tool for managing interest-rate risk comes to retail investors.

WisdomTree recently launched the market’s first negative-duration bond ETF—a fund that should offer investors broad exposure to one of the market’s most popular broad U.S. bond benchmarks while offering protection from rising interest rates.

The WisdomTree Barclays U.S. Aggregate Bond Negative Duration Fund (AGND) is essentially a long/short portfolio that serves up long exposure to the Barclays U.S. Aggregate Bond Index while seeking to manage interest-rate risk through the use of short positions in U.S. Treasury futures, according to the fund’s prospectus.

The idea of shorting Treasurys as a way of minimizing exposure to interest-rate risk has long been used in the institutional space, but AGND is the first example of an ETF issuer bringing a popular institutional-caliber solution to the ETF market.

The move speaks volumes to the pressure issuers are facing to meet investor demand for alternative ways of capturing yield in the current rising-rate environment. Now that the Federal Reserve said it will begin tapering its massive bond-buying program this month, more and more investors expect rates to move higher. Many have, in fact, projected yields on 10-year Treasurys will hit 3.5 percent by the end of this year, up from about 2.9 percent now.

In 2013, there was clear demand for shorter-duration bond funds exactly for that reason. More than $23 billion flowed into 0- to five-year duration fixed-income ETFs last year—to combat interest-rate sensitivity. As yields rise, bond prices decline.

How Negative-Duration Bond Portfolios Work

In the bond market, there’s a general rule of thumb that says for every 1 percent of interest-rate increase, the value of a bond portfolio will drop by the amount of its duration.

That’s to say that if an investor has a bond portfolio with a five-year duration and interest rates go up 100 basis points, that investor should expect a 5 percent decline in the value of the bond portfolio, WisdomTree’s head fixed-income strategist Rick Harper says.

What AGND does is invest in the same bonds comprising the Barclays Aggregate index—which currently has a duration of about 5.5 years—but it also shorts Treasury futures to a targeted total duration exposure of approximately negative five years.

 

“By incorporating Treasurys futures [as in AGND], you’d have something like 80 percent invested in the five-year duration portfolio, and the remaining 20 percent in the negative five,” Harper said. “By simple math, your overall portfolio interest-rate risk is now equivalent to that of a three-year Treasury, so for the same 100 percent interest-rate rise, you now expect only a 3 percent decline.”

Again, the longer-dated the bond portfolio is, the more sensitive it will be to that interest-rate hike, which is why so many investors have been shorting the duration of their bond allocations in recent months.

What’s also interesting about AGND is that, unlike most of WisdomTree’s other ETFs, this one is linked to the Barclays Aggregate index rather than to an in-house benchmark.

The reason for that is so that investors who already own exposure to the Barclays Aggregate index can supplement, or hedge the interest rate associated with that position rather than have to move into a completely new strategy, WisdomTree’s Chief Investment Strategist Luciano Siracusano said.

“A lot of people already own the Agg, it’s a core position in their portfolio and they have embedded capital gains on it,” Siracusano told IndexUniverse. “But the Agg right now has a duration of about 5 ½ years, and the interest is only 2.4 percent. It’s one of the worst trade-offs it has ever had—very long duration, very little yield, and you’re in a rising-rate environment.”

As an example, if an investor were to invest $80 in a fund tracking the Barclays Aggregate, and $20 in AGND, “that would reduce their interest-rate risk from a five-year duration to a three-year duration, which is essentially a 40 percent reduction in overall interest-rate risk for a 20 percent capital commitment,” Harper added.

There’s no question that shortening the duration of a bond portfolio, while it minimizes interest-rate risk, also trims the potential yield. AGND certainly has a negative drag on portfolio yields, but the interest from the long position should generate enough to offset that, Harper says.

“Think of it as providing insurance to your bond portfolio; there’s a cost to that protection, which is the interest-rate drag,” Harper explained.


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