Should Investors Be Thankful for Interest-Rate-Hedged Bonds?
Investors are likely better served by traditional bond funds.
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.
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%).
If the hedged interest rate index didn't offer better performance when interest-rates rising offered such a significant tailwind, they are unlikely to offer better performance over most periods. Interest-rate-hedging funds also tend to have higher costs than non-interest-rate-hedge funds, which can erode their returns.
The Barclays U.S. Aggregate Zero Duration Index, which the WisdomTree Barclays U.S. Aggregate Bond Zero Duration ETF (AGZD) tracks, has not fared much better than the Citi Corporate Investment Grade (Treasury Rate-Hedged) Index. While it provided slightly better risk-adjusted returns during the first rising-interest-rate period, it does so at a significant reduction to total returns. Further, during the second period of rising interest rates, it provided worse risk-adjusted returns. Even if an investor could correctly guess when interest rates were going to rise, the risk/reward trade-off does not seem very attractive for these funds.
Interest-rate hedging requires two different securities to work. At the beginning of the month, when the interest-rate hedge is put on, the duration match will be exact. But duration is only an approximation of how a bond's price changes with interest rates. As interest rates move the duration of the long- and short-positions may change at different rates leaving investors with only a partial hedge. This occurs when the long and short bonds have different convexities. (Convexity explains how duration changes with interest rates.)
Corporate bonds and the Treasury futures investors use to hedge their interest-rate risk often have different convexities. Bonds with smaller coupons tend to be more convex, while high coupon bonds tend to be less convex. This means that Treasury bonds will generally have higher convexity than a similar duration corporate bond. As a result, the Treasury bond's price should decrease less than a corporate bond's when interest rates rise. This can cause a mismatch in the portfolio's duration hedge and leave investors with positive duration. This matter is compounded when the Treasury yields are low, as they are now. This gives Treasury bonds a higher convexity and makes them more sensitive to interest-rate changes.
Because of the shortcomings of interest-rate-hedged bond funds, including higher costs and reduced yield, investors are best to stick with non-interest-rate-hedged bond funds.
Investors looking to reduce their overall interest-rate risk are likely better served by combining a low-cost short-term bond fund, such as Vanguard Short-Term Corporate Bond ETF (VCSH) (0.12% expense ratio), with an aggregate bond portfolio. This will help reduce the portfolio's overall duration and interest-rate risk, while keeping costs low.
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Thomas Boccellari does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.