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It's now or never for 'hedged' bond ETFs

These fixed-income funds were designed for just this type of market environment.

  • By Ari I. Weinberg,
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A number of fixed-income exchange-traded funds include hedges designed to mitigate the effects of rising rates. Many of these products, launched a few years ago for just this type of environment, have been performing as their builders intended.

Here’s a starter guide to a barely scratched corner of the fixed-income ETF market.

Spot the hedge

In a rising-interest-rate environment, hedging can be key to keeping a bond ETF above water. According to research firm XTF Inc., 60% of fixed-income ETFs were down for the year through Oct. 29 as the target federal-funds rate moved higher over the course of the year. By contrast, the handful of hedged fixed-income ETFs are showing positive performance.

Several products from BlackRock Inc.’s (BLK) iShares, WisdomTree Holdings, ProShare Advisors LLC and DWS Group’s Xtrackers are achieving this performance—up between 2% and 6% year to date, and attracting assets—by hedging a variety of risks, including interest-rate moves and inflation expectations. Slightly more expensive and much less liquid than their plain-vanilla cousins, these ETFs can be used to reduce volatility while still delivering yield.

“Hedging was actually detrimental to performance for the first couple of years for many of these products,” says Todd Rosenbluth, New York-based director of ETF and mutual-fund research for CFRA. “But now a few have developed a track record and more significant assets and volume,” Mr. Rosenbluth says.

Employed effectively as part of a fixed-income portfolio, Mr. Rosenbluth says, several of these products have offered both reduced volatility and a greater risk-reward profile then their unhedged cousins. Yet of the $65 billion in net assets added this year to the $600 billion managed by fixed-income ETFs, most of the new money is going to short-term and floating-rate bond ETFs, traditional products less likely to get whipsawed by rising rates, and core offerings favored in diversified asset allocations. Hedged fixed-income ETFs collectively added $850 million this year through Oct. 24, according to ETF.com.

While many of the products have similar-sounding names, their underlying holdings or indexes and their hedging mechanisms can vary. The focus of each product tends to vary from the aggregate bond market to investment-grade corporate securities to high-yield debt to emerging markets.

Interest-rate hedging

To understand how interest-rate-hedging ETFs work, it helps first to understand the concept of duration, a measurement based on the timing of interest payments and return of principal for individual bonds. Expressed in years, duration can also be used to gauge sensitivity to interest-rate fluctuations. Generally, a one-percentage-point move in rates (up or down) will shift the price of the bond or bond portfolio in the opposite direction, multiplied by the duration. So, a rise in rates of 1 percentage point would sink the price of a five-year-duration bond or bond portfolio 5%.

Interest-rate-hedged ETFs are manufactured to have a duration of approximately zero. For example, ProShares Investment Grade Interest Rate Hedged ETF (IGHG) and Deutsche X-trackers Investment Grade Bond Interest Rate Hedged ETF (IGIH) attempt to do this by selling Treasury futures contracts that rise in value when Treasurys lose value—i.e. when interest rates rise. This gain (or potential gain) helps to offset the decline in price of the bonds held by the ETF.

Alternatively, an ETF could use a type of financial derivative known as an interest-rate swap to achieve the same effect. The actively managed iShares Interest Rate Hedged Corporate Bond ETF (LQDH) does this by holding shares of the $31.6 billion iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) and by selling derivatives that entitle the ETF to floating payments in return for fixed payments. If interest rates move higher, the ETF receives cash that can help to offset any price decline in its core holding, in this case LQD.

“The rates-hedging instruments can be seen in the disclosed holdings, and their effectiveness can be measured,” says Raj Sharan, director of quantitative analytics and risk at Savos Investments, a division of AssetMark Inc.

Each of the issuers admonishes investors that these products are built mostly for quick, steep interest-rate moves, exactly like those experienced over the past several months.

“It’s a way to reduce risk in a rising-rate environment,” says Brad Krom, associate director of research at WisdomTree Investments, which launched a suite of hedged products five years ago on the day the Fed began tapering its bond purchases, including the $294 million WisdomTree Interest Rate Hedged High Yield Bond Fund (HYZD).

One catch, says Mr. Krom, is that the hedged products deliver a “net yield,” which covers the cost of the hedging activity in the distributions made to investors, which means the yield will be less than it is for unhedged products.

Negative duration and more

While the interest-rate-hedged fixed-income ETFs simply seek to eliminate the risk of rising rates, WisdomTree also has hung a shingle for products that attempt to actually goose returns for those looking to take a more aggressive stance in a rising-rate environment.

With roughly $100 million collectively in Negative Duration High Yield Bond (HYND) and Negative Duration U.S. Aggregate Bond (AGND), the WisdomTree products target minus 7 and minus 5 duration, respectively. So a rate rise of 1 percentage point would send the price of HYND up 7%. Such exposure would supercharge fund returns in a period of aggressive rate increases—but also leaves it more vulnerable to losses if interest rates stay the same or fall. If rates fall one point, the price of HYND would fall 7%.

Other products, such as short-bond ETFs from ProShares and Direxion, reset their exposure daily and are built for active traders. And, of course, investors always have the option to carry out a short trade on their own, but will take on the associated carrying costs of borrowing an ETF.

Another possibility

iShares Inflation Hedged Corporate Bond ETF (LQDI), launched in May, takes a similar approach to LQDH but uses futures and swaps based on a measure of inflation. While only a few months into existence, this fund may not fare any better with investors than the $14 million ProShares Inflation Expectations ETF (RINF) launched in 2012 that is long U.S. Treasury inflation-protected securities and short conventional Treasurys.

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