5 Ways To Manage Interest Rate Risk

Deciding how to hedge interest rate risk begins with a personal assessment: what kind of fixed income investor are you?

The Federal Reserve may not have raised rates this month as many had anticipated, but, by and large, most economists and market experts say rates are headed higher, and sooner rather than later. If the era of post-financial-crisis, ultra-low rates is indeed coming to an end, managing that transition to higher rates is imperative.

But how does an investor know what to do? Fortunately, there are different ways to manage a portfolio in a rising-interest-rate environment. It’s not just about reducing interest-rate risk and duration, it’s about sticking to what you are trying to achieve in your overall portfolio.

Different people have different risk tolerances, and they want different things out of their fixed-income allocation. Some turn to fixed income merely for diversification; some hunt for yield; some just want predictability of income at the end of the road.

So the question is, what kind of fixed-income investor are you?

We outline below five broad groups of investors, and the solutions that may apply to them.

1. The Diversifier

“If there’s someone who looks at fixed income as ballast to their portfolio, a ballast against equities, they may not want to reduce interest-rate risk at all,” Matt Tucker, head of fixed income for iShares, told ETF.com.

The reason for that, he says, is due to the historical low or negative correlation between stocks and bonds. To many, fixed income is a diversifier to equity exposure, and a lot of that diversification benefit comes from the interest-rate risk that bonds have.

“A typical investor who is investing in a fund such as the iShares Core U.S. Aggregate Bond ETF (AGG | A-98) may want to hold on to that investment, because even in a rising-rate environment, they are going to get the diversification benefits of that exposure,” Tucker said.

“Timing a rising-rate environment is very difficult,” he added. “For the investor who is long-term-minded and looks at fixed income as a diversifier, they should be comfortable leaving that allocation as it is.”

2. The Safe-Haven Seeker

Investors who want to make an adjustment to their exposure because they have a particularly strong conviction that rates will rise might want to reduce interest-rate risk.

“The most common solution here is to move into shorter-maturity, fixed-income vehicles that offer less interest-rate risk, and are less impacted by rising rates,” Tucker said.

Within the ETF market, asset flows have been recently going into higher-grade short-maturity funds such as the iShares Short Maturity Bond ETF (NEAR | A), which has duration of around one year. Funds like the Pimco Enhanced Short Maturity Strategy (MINT | B) is another one benefiting from interest-rate jitters.

Since Aug. 1 alone, NEAR and MINT have gathered more than $332 million and $572 million, respectively. That reposition is a response to concerns about higher rates.

3. The One Who Wants It All

There are investors who want to take some interest-rate risk off the table but they still want to participate, or “benefit,” when the Fed does begin to raise interest rates, Tucker said. For these folks, the most appealing category of fixed-income ETFs is those comprising floating-rate securities.

Floating-rate bonds have a coupon payment that resets regularly, and are often linked to the Libor, which in turn is tied to the fed funds rate.

“What you will see is that if the Fed raises interest rates, the actual coupon and yields from the fund will increase along with rising rates,” Tucker said. “That’s a way of not only being defensive against rising rates, but benefiting from when rates do move higher in the short end.”

The iShares Floating Rate Bond ETF (FLOT | 77) is one of the biggest in the segment, with some $3.7 billion in assets. The fund owns investment-grade floating-rate corporate bonds with maturities of zero to five years.

Other options include the SPDR Barclays Investment Grade Floating Rate ETF (FLRN | 77), which has $387 million in assets, and the Market Vectors Investment Grade Floating Rate (FLTR | B-68), with $90 million in AUM.

4. The Bond Ladder-er

Many fixed-income investors like to own actual individual bonds rather than bond funds. They do so to have certainty about their time horizon and the yields coming from their investment.

In the fund space, these types of investors tend to like bond laddering, which, thanks to iShares and Guggenheim, today is easily achievable via ETFs. Both firms have extensive lineups of single-bondlike funds that allow investors to build bond ladders and manage their risk.

These types of ETFs, such as the Guggenheim BulletShares 2015 Corporate Bond (BSCF | B) and its family of target-date funds, or the iShares iBonds Mar 2016 Corporate ex-Financials (IBCB | C-45), are popular here because they have a finite maturity date.

“Investors are drawn to bond ladders in the context of a rising-rate environment because when you buy a bond, you buy it at a yield,” Tucker said. “You know your cash flow regardless of what interest rates do.”

These types of ETFs are essentially a yield investment, and you get a lump-sum payment at the end, and a yield based on cash flows.

“Investors who have set-time horizons, or those who want yield and want a better idea of what they are getting down the road, like this option,” Tucker said. “Bonds are generally held through maturity in the fund, and return par no matter what happens with interest rates.”

5. The Hedger

Finally, there’s an emerging tool in the ETF investor fixed-income kit that’s quickly gathering a following: interest-rate-hedged funds.

What’s interesting about these types of ETFs—such as the Deutsche X-trackers Investment Grade Bond - Interest Rate Hedged (IGIH), the iShares Interest Rate Hedged Corporate Bond (LQDH) and a roster of other funds, is that they appeal more to wealth managers and institutions because they have derivatives built into them, Tucker says. LQDH, for example, owns bonds and interest-rate swaps to hedge interest rates.

“The idea here is that you get exposure to corporate bonds, but take out interest-rate risk from those securities,” Tucker said. “By doing that, you are giving up the yield you would receive on the risk, but you are still picking up some yield and maintaining exposure to a market—in this case, corporate bonds.”

Hedged ETFs, when used as part of an allocation that also includes unhedged ETFs, allow investors to be more precise about how much interest-rate risk they want exposure to, Tucker notes. The other key thing to remember with this approach is that you might be protected from interest-rate risk, but you will be highly exposed to credit risk tied to the corporate bond market.

Charts courtesy of StockCharts.com

Contact Cinthia Murphy at [email protected]