How To Use Bond ETPs Before Rate Hikes

The spectre of rising interest rates has haunted bondholders in the past few months, following speculation that the first U.S. rate hike would arrive as early as the third quarter.

China’s economic slowdown and the ensuing global stock market volatility in August granted bond investors reprieve, by pushing back the chances of an imminent rate increase amid the instability.

However, the prospect of a rate rise remains, threatening to reduce the value of investors’ bond holdings and dry up liquidity in corporate bond markets.

Clever Bond ETFs

Experts believe ETFs, which price intraday and provide liquidity, are an efficient way to access the asset class for investors in need of bond exposure, whether for diversification, a steady income stream or to fulfil an institutional mandate.

Adam Laird, a passive investment manager at Hargreaves Lansdown, said: “ETFs are an efficient way to gain access. They are one of the lowest cost ways to get exposure to high yield bonds and emerging market debt, for example, and that’s very appealing.”

ETF providers are preparing for potential rate increases, which in certain developed economies will be the first since the financial crisis, by launching products that aim to cushion the impact upon bond prices.

Laird said: “Rate rises normally mean a fall in bond value – ETF providers have been clever in the way they deal with this.”

Peter Sleep, a fund manager at Seven Investment Management, said: “A lot of short duration bond funds, tracker funds and ETFs have been issued to try to mitigate the impact of rising inflation and falling bond prices.”

iShares, for example, launched a range of interest rate hedged ETFs which go long corporate bonds and short government debt. The iShares £ Corporate Bond Interest Rate Hedged UCITS ETF (SLXH) directly invests in corporate bonds across a range of sectors, and sells gilts to reduce the effect of rate movements.

Go Short Or Active?

Short exposure to long-dated gilts and government bonds is another way to position for a rate rise, although Laird cautions such products are not for the “faint-hearted” nor inexperienced investors.

One offer from Boost ETP is the Gilts 10y 3x Short Daily ETP (3GIS). The product aims to deliver three times the inverse performance of an index that tracks front-month long-gilt futures, on a daily basis.

Actively managed ETPs have also emerged in the government bond space, and could serve as a more nimble alternative to traditional index trackers.

Laird highlights Pimco’s “Quid” in this space, which utilises active management to select sterling-denominated securities including government bonds, with a weighted average maturity of no more than three years.

Rate Hike – Unlikely Impact On Government Debt

Although these specialised ETPs are designed to cushion the blow of a rate rise, some experts believe these particular fears are overblown.

Jeremy Beckwith, a director at Morningstar UK, said that the U.S. Federal Reserve chair Janet Yellen last week “sounded more hawkish”, suggesting rates could be raised before the end of this year.

“But they’ve also been clear that they will raise rates slowly,” he said. “We’ve expected one for the best part of a year.”

He added that a rate rise is unlikely to have a significant impact on Treasuries or gilts, unless markets believe it is the start of an accelerating trend of tighter monetary policy, which would require stronger economic data.

Bond Bear Market Ahead

Shaun Port, chief investment officer at wealth manager Nutmeg, agreed that fears are overblown, although believes the “bond bear market has begun”.

He said that the Federal Reserve is “keen to stress that starting early means that it will be able to take its time”, and that a normal rate is still likely to be low, in the region of 2 to 3 percent.

“We do not fear a dramatic loss for bond holders like in 1994, but the current situation still warrants a cautious approach,” he said.

Liquidity Concerns

Port has been cutting duration significantly, while also reducing holdings in corporate bonds because of concerns over future liquidity.

“Liquidity risks are well flagged, so investors should not be surprised if we see a liquidity crunch at some point,” he said. “It is worth remembering that any fixed income, apart from some part of the government curve, is not a liquid asset class.”

He added that tight liquidity is a reason for holding short-dated bonds, as redemption payments are made by the issuer when bonds mature and tend to be traded more frequently than longer-dated bonds. Port is currently holding the SPDR Barclays 0-5 Sterling Corporate Bond UCITS ETF (SUKC), the SPDR Barclays 1-5 Year Gilt UCITS ETF (GLTS), and the Vanguard UK Government Bond UCITS ETF (VGOV).

Other Catalysts For Fixed Income

Some fund managers believe interest rates are less of a driver for bond prices than other factors.

Sleep at Seven Investment Management said the markets’ perception of future inflation rates is a more significant driver. “It does not necessarily follow that higher short term interest rates will lead to lower bond prices, if the market perceives that inflation will be held in check by the interest rate rise,” he said. “What damages bond prices is rising inflation, which kills the value of a bond and fixed bond interest. Inflation is like kryptonite for bonds.”

Although ETFs can bring a degree of liquidity and investors have a greater selection of bond-focused products from which to choose, there are still drawbacks.

Laird notes that using shorter-term investments means sacrificing yield to protect against falling bond prices. He added that investors must also beware of piling in to such products after rates have already risen.

Rate Hike “Not Inevitable”

While speculation is mounting over timing, a rate rise is not inevitable as some might suggest. Sleep said: “It is not clear yet that UK interest rates will have to rise.” He points out that the Bank of England’s chief economist, Andrew Haldane, speculated last week that interest rates might still have to be cut further in the UK.

In spite of the debate over when and if a rate rise will occur, ETF providers are positioning for every outcome with the launch of a wider range of products tailored to mitigate the impact upon bonds.

For investors, the choice is welcome, while providing a solution to the search for yield as rates hover at record lows – at least for the time being.