EC Do Rate-Hedged Bond ETFs Work?

The problem with fixed income investments isn’t the income. Not directly, anyway. It’s the value of that income in relation to prevailing market rates. The laws of bond physics dictate that the resale price of a 3 percent coupon is likely to be diminished if yields rise to 4 percent. This manifestation of interest rate risk is especially worrisome for holders of bond ETFs. For traditional bond ETFs, that is.

Over the past few years, a slew of rate-hedged bond ETFs have launched with an eye toward mitigating the deleterious effects of rising yields. The hedge is accomplished by shorting Treasury futures or entering into swap agreements that offset the overall duration of the bond portfolio. Swaps entitle the ETF to floating payments tied to prevailing interest rates in return for a series of fixed disbursements. If rates rise, the increasing cash sums received by the ETF help to offset declines in the value of the underlying bond portfolio.

Duration combines the timing of interest payments and the return of principal into a gauge of a bond or bond fund’s relative value. Expressed in years, duration is most commonly known to investors as an estimate of an instrument’s sensitivity to interest rate fluctuations. A one-percentage-point shift in rates will generally push a bond portfolio’s value in the opposite direction by a like amount, multiplied by the security’s duration. You’d, therefore, expect the value of a bond ETF with a five-year duration to slump by 5 percent in response to a one-percentage-point hike in rates. Interest rate-hedged ETFs are designed to have a duration approximating zero.

Mind you, duration hedging doesn’t wipe away the entirety of a bond ETF’s risk. Neutralizing interest rate risk merely isolates the portfolio’s credit risk—in other words, the danger of default. With that, ETF holders become exquisitely sensitive to changes in economic conditions that affect default rates. This makes rate-hedged ETFs a good bet when investor sentiment about economic growth and corporate earnings is positive. When credit conditions worsen, however, the hedge is a drag. At the very least, a portfolio hedge should dampen the volatility found in a traditional bond ETF. That, in turn, ought to produce a performance advantage. 

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David Vomund 2 years ago Contributor's comment

Good analysis, thanks.