These ETFs Can Help Fight Interest-Rate Risk

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.

There are, however, higher-yielding short-term bond ETFs that take on additional credit risk.

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.

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.

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.

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.

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