Journal of Financial Planning: July 2015
Tom Lydon is editor of ETFtrends.com and president of Global Trends Investments, a registered investment adviser. He is a frequent contributor to major print, radio, and television media.
The Federal Reserve is pushing off interest rate hikes, but bond investors will eventually have to contend with a rising-rate environment. Instead of shifting a fixed-income portfolio down the yield curve or into cash to diminish the effects of rising rates, consider an interest-rate-hedged bond ETF to potentially enhance returns.
Interest-rate-hedged bond ETFs mix long fixed-income securities with short positions in Treasury bonds to maintain a zero-duration portfolio. With a targeted zero duration, these relatively new ETFs should show little to no sensitivity to rising rates and produce the same level of yields many have grown used to.
For starters, the WisdomTree Barclays U.S. Aggregate Bond Zero Duration Fund (AGZD) offers a rate-hedged alternative to the traditional U.S. Aggregate Bond Index. AGZD shows a similar mix of debt securities as the Aggregate Bond Index and comes with a 1.35 percent, 30-day SEC yield. However, unlike other bond funds that track the Aggregate Bond Index, AGZD has an effective duration of 0.0 years. Consequently, the fund should exhibit zero sensitivity or experience no ill effect in a rising-rate environment.
However, be aware that because the fund hedges its rate risk through short Treasury positions, a zero-duration rate-hedged bond ETF may underperform traditional bond funds if interest rates were to fall.
Advisers seeking a little more yield can consider hedged corporate bond ETFs. Interest-rate-hedged, investment-grade bond ETF options include the iShares Interest Rate Hedged Corporate Bond ETF (LQDH), ProShares Investment Grade-Interest Rate Hedged ETF (IGHG), and the recently launched Deutsche X-trackers Investment Grade Bond–Interest Rate Hedged ETF (IGIH). LQDH has a 3.15 percent, 30-day SEC yield and a 0.13-year duration. IGHG has a 3.21 percent, 30-day SEC yield and a –0.18 year duration.
The iShares offering is a play on the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD), except LQDH takes short positions in five-year and two-year Treasury notes. IGHG and IGIH track a portfolio of corporate debt securities and take on short positions in 10-year and longer dated Treasury contracts to achieve their target hedge.
For high-yield options, advisers have a number of hedged bond ETFs to choose from. The iShares Interest Rate Hedged High Yield Bond ETF (HYGH) has a 5.31 percent, 30-day SEC yield and a 0.35-year duration. The WisdomTree BofA Merrill Lynch High Yield Bond Zero Duration Fund (HYZD) has a 4.11 percent, 30-day SEC yield and a –0.13-year duration. The ProShares High Yield Interest Rate Hedged ETF (HYHG) has a 5.9 percent, 30-day SEC yield and a –0.13-year duration. The Market Vectors Treasury-Hedged High Yield Bond ETF (THHY) has a 4.13 percent, 30-day SEC yield and a 0.17-year duration. Lastly, investors can take a look at the Deutsche X-trackers High Yield Corporate Bond–Interest Rate Hedged ETF (HYIH).
The iShares hedged high-yield option also follows the popular iShares iBoxx $ High Yield Corporate Bond ETF (HYG), except HYGH includes short positions in two-year and 10-year Treasury notes. On the other hand, HYZD, HYHG, THHY, and HYIH include a basket of junk and some low-quality, investment-grade debt securities along with short positions in a basket of U.S. Treasuries. Each bond portfolio is unique, so investors should check the sector and credit qualities.
Advisers can also track emerging markets through the Deutsche X-trackers Emerging Markets Bond–Interest Rate Hedged ETF (EMIH). The portfolio is a basket of U.S.-denominated emerging market debt taken from 29 countries and also includes short Treasury positions. As is the case for all bond funds, rising interest rates are also a risk to ETFs that track emerging market debt.
An interest-rate-hedged, long/short credit fund can provide a buffer in a rising-rate environment and even generate greater returns based on the level of exposure provided. To cushion against the upcoming Fed tightening, consider a zero-duration bond ETF strategy ahead.