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These ETFs Can Help Fight Interest-Rate Risk

None of the options is perfect, but there are several fixed-income ETFs for investors looking to manage the threat of rising rates.

Phillip Yoo, 05/24/2017

It is difficult to successfully time market events such as movements in key interest rates—this is hardly a controversial statement. However, it is still prudent to manage risk. Take interest-rate risk as an example. Unanticipated rate increases can hurt investors' fixed-income portfolios. Because such events are, by definition, unanticipated, they are nearly impossible to time. But that is not to say that investors must leave themselves completely vulnerable to the associated risk. Here, I will explore several options from the menu of fixed-income ETFs, and beyond, that might help investors better manage interest-rate risk in their portfolios.

Cash
Cash is the mother of all hedges. The most conservative approach for investors concerned about interest-rate risk is to liquidate some of their fixed-income holdings and raise cash. While cash takes all interest-rate risk out of the equation, it has notable weaknesses. Most importantly, after moving into cash investors must decide when to redeploy it. Raising cash and then putting it back to work in such fashion is effectively market-timing. Uncertainty, one of the risks that the investor sought to avoid by raising cash in the first place, comes back into the equation when they look to redeploy it. This simple solution is not free, either. Whether selling current positions at a gain or loss, there will be transaction costs. In addition, investors can incur capital gains taxes by selling at a gain. Finally, cash currently offers practically no return. In fact, cash will earn a negative real return in today's rate environment. 

Short-Term Bonds
Short-term bond exchange-traded funds typically offer higher yields than cash and provide a low-cost path to dial back interest-rate risk. Schwab Short-Term US Treasury ETF SCHO (expense ratio: 0.06%) and Vanguard Short-Term Government Bond ETFVGSH (expense ratio: 0.07%) are the lowest-cost short-term bond ETF options. However, drawbacks applicable to cash, including transaction costs for selling existing holdings and buying new short-term bond ETFs, tax considerations, and market-timing risk apply to short-term bonds as well. In addition, as is the case with cash, SCHO and VGSH currently have negative real yields. Both funds had SEC yields around 1.2% as of May 22, 2017, which was lower than the 2.2% inflation rate. 

There are, however, higher-yielding short-term bond ETFs that take on additional credit risk. Vanguard Short-Term Corporate Bond ETF VCSH (expense ratio: 0.07%) and iShares 0-5 Year Investment Grade Corporate Bond SLQD (expense ratio: 0.08%) invest in investment-grade corporate bonds with maturities less than five years. However, these yields are still below inflation rate, and both funds had an SEC yield around 2.0% as of May 22, 2017. Investors who can stomach still more credit risk can consider going further down the capital structure and invest in short-duration high-yield funds. iShares 0-5 Year High Yield Corporate Bond SHYG (expense ratio: 0.30%) and SPDR Bloomberg Barclays Short-Term High Yield Bond ETF SJNK (expense ratio: 0.40%) provide exposure to bonds issued by companies with higher default risks. Accordingly, these funds offer SEC yields around 5.0% as of May 22, 2017. 

Interest-Rate Hedged Bond ETFs
Like a typical bond ETF, interest-rate hedged bond ETFs track an index. However, the funds employ rate-hedging mechanisms—such as shorting Treasury futures—to all but eliminate the fund's interest-rate risk. IShares Interest Rate Hedged Corporate Bond LQDH (expense ratio: 0.25%) takes a long position in its sister investment-grade corporate bond ETF, IShares iBoxx $ Investment Grade Corporate Bond LQD and a short position in interest-rate swaps. ProShares Investment Grade—Interest Rate Hedged IGHG (expense ratio: 0.30%) offers exposure to U.S.-dollar-denominated investment-grade debt, and uses Treasury futures to target a zero duration. Arguably, these ETFs could achieve the objective of reducing duration risk while maintaining credit exposure. Both funds have been around only for a few years, but they have been successful in hedging interest-rate risk—maintaining a duration close to zero. 

While these funds do reduce interest-rate risk, they tend to behave like stocks. In fact, their monthly return correlation with the S&P 500 from June 2014 to March 2017 was 0.65. Investors tend to hold bonds to diversify equity, as bonds tend to go up when stocks go down, and vice versa. However, these rate-hedged ETFs diminish the diversification benefit of bonds, as exemplified by their relatively greater correlations to stocks versus their unhedged counterparts. In addition, these funds may be costly to trade, given their small asset bases and low trading volume. 

Senior Loan ETFs
Senior loans are issued by companies with sub-investment-grade credit ratings. They are somewhat less credit risky relative to junk bonds, as the borrower will often pledge assets against the loan. Senior loans have little sensitivity to interest-rate risk as their coupon payments float with prevailing interest rates and typically reset once a quarter. As a result, the duration of these loans tends to hover near zero. SPDR Blackstone/GSO Senior Loan ETF SRLN (expense ratio: 0.70%) is a persuasive option for senior loan exposure. This actively managed ETF is managed by Blackstone/GSO, one of the largest credit managers, with more than $90 billion in assets under management. Its sponsor's scale enables the fund to access primary and secondary loan assets that are otherwise not available to many other senior loan funds, giving it greater opportunities to add value. 

SRLN's interest-rate risk is low, but its liquidity and credit risk are high. While the fund provides daily liquidity, its holdings are rarely traded. Also, this fund invests in sub-investment-grade loans, which tend to have a greater probability of default relative to investment-grade credits. This is an instance where investors are substituting liquidity and credit risk for interest-rate risk. 

Inverse ETFs
Inverse leveraged fixed-income ETFs are designed to profit as interest rates rise and bond prices fall. These vehicles allow investors to express a negative view on different segments of the fixed-income market. However, these are a far cry from a conventional short sale. The fact that these funds' leverage ratios reset on a daily basis means that their long-term (as in, more than one day) returns will leave investors disappointed. ProShares UltraShort 20+ Year Treasury TBT (expense ratio: 0.93%) is a useful example. The fund offers exposure to twice the inverse daily performance of the ICE U.S. Treasury 20+ Year Bond Index. IShares 20+ Year Treasury Bond TLT (expense ratio: 0.15%) also follows the same index, but is strictly long and has no leverage. From TBT's inception in April 2008 through May 21, 2017, its annualized return was negative 19.89%. TLT's annualized return over that same span was 6.70%. This result illustrates a common misunderstanding of leveraged and inverse ETFs. Investors can mitigate the daily compounding problem by rebalancing their allocation on a regular basis, but this can be an expensive and inefficient way to hedge against rate risk.

Options on Bond ETFs
There are liquid options contracts for a handful of bond ETFs. The liquidity of these funds' associated options is correlated with the funds' trading volume. One of the most actively traded options on a bond ETF are put options on TLT. The put option gives the buyer a right, but not an obligation, to sell TLT to the option seller at the agreed-upon strike price. Therefore, when the value of TLT declines due to increases in key interest rates, the investor's loss is limited only up to the strike price. Buying put options on TLT is an attractive means of hedging interest-rate risk because TLT's long duration, 17 years as of May 22, 2017, makes the fund particularly sensitive to rate movements. To illustrate, if rates abruptly rise by one percentage point, this fund could lose approximately 17% of its value. In addition, TLT's value is mostly influenced by its duration risk, as the Treasury bonds that make up its portfolio have virtually no credit risk. But while buying put options can offer some downside protection, they are expensive. Buying put options is similar to buying a car insurance. Over time, one's outlays for insurance premiums will eventually exceed the value of the insured car. If an investor regularly buys put options, returns will be meaningfully reduced. Fortunately, unlike car insurance, investors can decide whether they want the put option or not—though the challenge of timing rears its head here once again.

Conclusion
None of the various rate-hedging strategies I've described here is particularly easy to implement in a low-cost manner. Each comes with its own caveats. The most important of those warnings is that history has proven that market-timing is impossible. While it is important to understand the broad array of tools for combating interest-rate risk, the best weapon for defending one's portfolio might be time. As rates rise, investors and the funds they own will reinvest dividends, coupon payments, and the proceeds of any maturities at the prevailing—and presumably higher—rates.

 

Disclosure: Morningstar, Inc. licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.

 

Phillip Yoo is an analyst, passive strategies research, for Morningstar Research Services LLC, a wholly owned subsidiary of Morningstar, Inc.

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