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ETF Specialist

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

Investors are likely better served by traditional bond funds.

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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.

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Thomas Boccellari does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.