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Should Investors Be Thankful for Interest-Rate-Hedged Bonds?

Investors are likely better served by traditional bond funds.

Thomas Boccellari, 11/26/2014

Coupon payments generated nearly 90% of the Barclays U.S. Aggregate Bond Index's returns since its inception in January 1975, despite falling interest rates, which pushed bond prices higher and yields lower. Yet, nearly all of this index's volatility came from changes in bond prices, caused by changes in interest rates. Because changes in bond prices tend to generate a minority of the total return and most of the risk, interest-rate hedging seems like a promising way to significantly reduce price volatility without giving up much return. However, this hasn't been the case.

Investors can hedge interest-rate risk by reducing duration, a measure of a bond price's sensitivity to interest rate movements, to zero. Because individual zero duration bonds do not exist, interest-rate-hedged bond funds short Treasury futures to bring the portfolio's duration to zero. For example, at the end of October 2014, SPDR Barclays High Yield Bond ETF JNK had a duration of 4.3 years. This means that for every 1% increase in interest rates, the fund will likely lose about 4.3%. An investor looking to decrease that duration to zero could short a five-year Treasury Note futures contract, which has a similar duration. The short Treasury future position cancels the long corporate bond positions. This creates a portfolio with almost no interest-rate risk. If interest rates were to increase 1%, the long portfolio would decline roughly 4.3%. However, the short position would appreciate roughly 4.3% and offset the decline leaving the investor with minimal--if any--losses. While it will detract from the investor's total yield, a Treasury that has the same duration as a corporate bond almost always has a smaller yield.

On paper, this sounds fantastic. By removing one of the two major factors of bond price volatility, investors are essentially left with only credit risk. However, interest-rate hedging is not free. In addition to the transaction cost of shorting the treasury future, the investor foregoes interest to short the Treasury futures. For instance, at the end of October 2014, the ProShares Investment Grade-Interest Rate Hedged IGHG bogy, the Citi Corporate Investment Grade (Treasury Rate-Hedged) Index, had a long portfolio yield of 3.9% and a short portfolio yield of 2.4% leaving investors with a 1.6% yield.

Historical Performance
If historical performance is an indication, the cost of interest-rate hedging is probably not worth it. For example, the Citi Corporate Investment Grade (Treasury Rate-Hedged) Index underperformed the Bank of America Merrill Lynch U.S. Corporate A 10-15 Year Index over the past few years, despite both having a similar duration (nine-plus years) and credit rating (A). Over the trailing five years through October 2014, the interest-rate-hedged index generated a 2.9% annualized return, while the non-interest-rate-hedged index posted a 7.4% return. This is not surprising because interest rates, on average, declined over this period helping the non-interest-rate-hedged index's performance. Additionally, the hedged index offered a lower yield--which accounts for a majority of a bond fund's returns.

However, what is surprising is the two indexes' volatility. The interest-rate-hedged index's annualized standard deviation over the trailing five years through October 2014 (8.1%) was actually higher than that of the non-interest-rate-hedged index (6.1%). This may be partially because the Treasury bonds, which the index shorts, were more volatile than corporate bonds. For example, the Barclays U.S. Treasury 7-10 Year Index's trailing five-year volatility through October 2014 (6.2%) was greater than that of the Barclays U.S. Corporate Investment Grade Index (4.2%). This could be partially explained by weak correlation (0.6) between the long corporate bonds and short Treasury futures over the trailing five-year period. Instead of the volatility of the two portfolios offsetting, it became additive. Another possible reason is that lower-coupon bonds, like Treasuries, tend to be more sensitive to rate changes than similar maturity bonds with higher coupons. Effectively, investors were giving up yield for poorer returns and more volatility than a non-interest-rate-hedged portfolio--not a very attractive trade.

This comparison might be unfair, however. After all, the index was designed to perform well during periods of rising interest rates. Since the index's November 2008 inception, there have been two periods when the 10-year Treasury yield was increasing over a period of a year of more: December 2008 (2.42%)–April 2010 (3.85%) and July 2012 (1.53%)–December 2013 (2.90%).

Over the first period, the non-interest-rate-hedged index posted a 1.7% annualized return, despite the rising 10-year Treasury yield putting downward pressure on bond prices. However, the interest-rate-hedged index eked out a 0.20% return advantage, but with greater volatility (10.8%) than the non-interest-rate-hedged index (6.2%).

During the second period, the non-interest-rate-hedged index posted a 1.0% annualized return. However, the non-interest-rate-hedged index posted a negative annualized return of 0.1%. Once again, the interest-rate-hedged index had nearly 2 times the volatility (9.6%) as the non-interest-rate-hedged index (5.3%).

is an ETF Analyst with Morningstar.

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