ETFs To Hedge US Interest Rate Risk

If you’ve been waiting for an actual rate hike to take place before adjusting your bond portfolio, you might have already been losing money.

The Fed has yet to take action on raising the fed funds rate, but other interest rates such as Treasury yields have already been rising—to the detriment of many bond investors.

In a market commentary Friday, ProShares reminded us of the important distinction between the fed funds rate—the rate banks use among themselves to lend and borrow—and interest rates that are not determined by the Fed, but by “market forces.”

Uncorrelated Movements
At the end of the day, these two types of rates can have completely uncorrelated movements, which was the case in the April-to-June period ProShares singled out. Then, as the fed funds rate sat quietly, 10-year Treasury yields rose more than 60 basis points.

For an ETF investor with exposure to 10-year and longer-dated debt through funds such as the iShares 7-10 Year Treasury Bond ETF (IEF | A-51) and the iShares 20+ Year Treasury Bond ETF (TLT | A-85), this period of quiet in the fed funds rate looked like this for their portfolios:

TLT lost more than 11 percent in three months, and IEF bled 3.5 percent.

“It’s not uncommon for interest rates and the Fed Funds rate to move in the opposite directions,” ProShares said in the commentary. “Investors waiting for the Fed might have waited too long and missed the boat.”

When rates rise, bond prices tend to fall, and the longer-duration debt you own, the more sensitive your exposure is to those changes.

“So, what’s a concerned bond investors to do? Focus on what’s in front of you—the market,” ProShares said. In other words, don’t wait for the Fed.

Jobs Report Points To Hike
Friday’s strong jobs report—showing that 215,000 new jobs were created in July—served to reinforce the notion that the first fed funds rate hike in six years might come next month. That outlook has ProShares suggesting it might be prime time to consider minimizing duration risk, or hedging some of that risk.

Clearly, ProShares has products to sell here: its interest-rate-hedged ETFs, the ProShares Investment Grade - Interest Rate Hedged ETF (IGHG | B) and the ProShares High Yield - Interest Rate Hedged ETF (HYHG | C-37). IGHG owns investment-grade debt and shorts U.S. Treasurys to mitigate interest-rate risk; HYHG is a high-yield take on that theme.

And to be fair to ETF investors, a fund like TLT bled some $1.3 billion in assets during the April-June period, while IEF saw redemptions hit $190 million in that time frame. Indeed, ETF investors might be on the ball already.

But if you look past the self-serving nature of the note, the point is valid: Addressing interest-rate risk in a bond portfolio following a multiyear era of ultra low rates is crucial going forward because rates will rise.

‘Privy’ To Price Depreciation
As Clayton Fresk from Stadion Money Management recently pointed out, “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.”

And ProShares’ products aren’t the only tools available to ETF investors.

Fresk himself dissected 10 different strategies that aim at hedging interest-rate risk, including funds such as the WisdomTree Barclays U.S. Aggregate Bond Zero Duration fund (AGZD | B-41). AGZD tracks a long/short net-zero-duration bond index that’s long U.S. investment-grade issues and short Treasury futures, and is designed to tackle interest-rate risk.

Consider AGZD’s performance relative to TLT or even relative to a broad bond fund such as iShares Core U.S. Aggregate Bond ETF (AGG | A-98) during that three-month period:

Charts courtesy of StockCharts.com

Up until now, a lot of these relatively new-to-market interest-rate-hedged ETFs have seen asset growth to be slow. But their time to shine might be just about now.

Contact Cinthia Murphy at [email protected].