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As the Fed continues to reduce its Quantitative Easing program, and the market anticipates a likely increase in the fed funds rate next year, Matt Tucker explores ways to attempt to hedge against rising interest rates in your bond portfolio.

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I continue to get questions about how the Fed’s tapering of bond purchases, which is currently underway, will impact investors’ fixed income positions and how to best prepare a portfolio for rising interest rates. As I explained in a recent Blog post, we expect rates to rise gradually. There are several reasons behind this rationale, specifically: the Fed is gradually slowing down their bond buying program, and is expected to end it near the end of this year; the Fed has signaled that they likely won’t begin to raise short-term interest rates until the middle of 2015; and overall the Fed has indicated that they want to provide a lot of transparency into their thinking on interest rates, which should allow for policy shifts to be incorporated more slowly into bond prices and yields.

That being said, some investors are already thinking about how they want to position their portfolios for higher rates. The challenge that many of them have is that they want to adjust the interest rate sensitivity (commonly called duration) of their portfolios without sacrificing too much yield. This is especially true in investment grade and high yield investments, both of which are often used to generate income. Essentially investors are trying to achieve two different, and often competing goals:

  1. Mitigate interest rate risk. Lower duration means less interest rate risk. A duration of one year, for example, has less interest rate risk than a duration of ten years
  2. Generate yield. Reducing interest rate risk often means moving into shorter maturity bonds. These bonds do have less interest rate risk, and at the same time have less credit risk. Less risk is generally good, but it also typically comes with a reduction in yield.

So how can an investor manage duration, beyond investing solely in short duration bonds? An alternative approach is to utilize interest rate hedging. An interest rate hedge utilizes a short position in a US Treasury future or similar security to seek reduced interest rate risk. A fully interest rate hedged investment would have a duration of 0. Such an investment can still provide yield and would primarily be subject to corporate default risk as that portion of the portfolio isn’t being hedged. Such an interest rate hedged investment could be used in combination with an unhedged investment to seek a targeted level of interest rate risk. It’s a spectrum, or radio dial of sorts, that could be used to target the right level of interest rate risk for an individual investor. For example, if we take the iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSEARCA:LQD), we have a duration of 7.7 years. This duration may be a bit high for some investors, so to help reduce interest rate risk the fund could be combined with the iShares Interest Rate Hedged Corporate Bond ETF (NYSEARCA:LQDH), which has a duration of zero. By combining the two, we could potentially have a duration of zero, a duration of 7.7, or anything in between, depending on an investor’s risk tolerance.

We could do something similar with the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEARCA:HYG), a domestic high yield corporate bond ETF, which has a duration of 3.91 years. To potentially reduce this duration, we could combine HYG with the iShares Interest Rate Hedged High Yield Bond ETF (NYSEARCA:HYGH) which has a duration of 0.05 years.

The introduction of interest rate hedged ETFs gives investors another tool for managing interest rate risk. It joins short maturity funds, floating rate funds, and term maturity funds as ways for investors to customize the yield and duration of their fixed income portfolios. When we do begin to see interest rates rise, investors will have a full toolkit of fund options available to them.

Matt Tucker, CFA, is the iShares Head of Fixed Income Strategy and a regular contributor to The Blog. You can find more of his posts here.

The Interest Rate Hedged Funds are actively managed and do not seek to replicate the performance of a specified index. The Funds may have a higher portfolio turnover than funds that seek to replicate the performance of an index.

Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.

Securities with floating or variable interest rates may decline in value if their coupon rates do not keep pace with comparable market interest rates. The Fund’s income may decline when interest rates fall because most of the debt instruments held by the Fund will have floating or variable rates.

There is no guarantee that interest rate risk will be reduced or eliminated within the funds.

The Fund’s use of derivatives may reduce the Fund’s returns and/or increase volatility and subject the Fund to counterparty risk, which is the risk that the other party in the transaction will not fulfill its contractual obligation. The Fund could suffer losses related to its derivative positions because of a possible lack of liquidity in the secondary market and as a result of unanticipated market movements, which losses are potentially unlimited. There can be no assurance that the Fund’s hedging transactions will be effective. Investment in the Fund is subject to the risk of the underlying Funds.

Investing in long/short strategies presents the opportunity for significant losses, including the loss of your total investment. Such strategies have the potential for heightened volatility and in general, are not suitable for all investors.

Source: Hedging Rising Interest Rates