There is an ongoing debate about interest rates. Will rates rise or fall after the Fed completes its exit from quantitative easing? In the near term, the picture seems to favor lower rates, given that interest rates fell at the end of QE1, QE2 and since the taper of QE3 began. Out into 2015 though, the Federal Reserve is signaling that a slow return to normal monetary policy will start with an interest rate hike. For investors agreeing with the Fed's outlook and expecting solid economic growth along with higher interest rates, one way to hedge against rising rates while maintaining income is with high yield interest rate hedged ETFs. Investors need to understand the risk in these funds before investing though.
Reducing Interest Rate Risk
Interest rate hedged ETFs are attractive to investors because they offer high yield along with lower interest rate risk. Other ways of reduce interest rate risk generally involve accepting lower current income.
The easiest way to reduce interest rate risk is to reduce the duration of a fixed income portfolio. Duration is a measure of interest rate sensitivity and every ETF lists the duration of their bond fund on their websites. Long-term bonds have higher duration, i.e. more interest rate risk. Bonds with lower coupon payments also have higher duration. The bonds with the highest duration are long-term zero-coupon bonds. Exchanging iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT) for iShares 1-3 Year Treasury Bond ETF (NYSEARCA:SHY) will not only greatly reduce the risk from rising interest rates by lowering the duration, but it will also cut an investor's yield from more than 3 percent down to about 0.30 percent.
Another choice is floating-rate funds. These ETFs own debt securities with floating interest rates that reset as rates move up or down. The cost here is that investors are willing to pay higher prices for these bonds due to their protection from rising interest rates. The result is that the largest of the three floating-rate ETFs, iShares Floating Rate Bond ETF (NYSEARCA:FLOT), has a 30-day SEC yield of 0.30 percent.
Another option is to move into high yield, or junk bonds. High yield bonds have lower duration than Treasury or corporate bonds of similar maturity, due to their high coupon payments. iShares iBoxx $ High Yield Corporate Bond ETF (NYSEARCA:HYG) is one such fund. High yield bonds don't eliminate interest rate risk though, they only reduce it slightly, while adding credit risk.
Investors can take another step to further reduce interest rate risk: hedge their exposure by owning high yield bond ETFs that short bonds. ETFs, such as Market Vectors High-Yield/Treasury Bond ETF (NYSEARCA:THHY), employ this strategy in order to reduce interest rate risk. THHY holds high-yield bonds and shorts the 5-year U.S. Treasury. The result is a portfolio duration of 0.23, which is lower than even iShares Short Treasury Bond ETF (NYSEARCA:SHV). Investors can collect a yield of more than 4 percent while having very little exposure to interest rate risk.
If THHY is doing its job and hedging interest rate risk, then THHY should outperform an unhedged ETF such as HYG when the 5-year Treasury yield rises (thanks to gains from its Treasury short position) and it should underperform HYG when the 5-year Treasury yield falls (due to losses on the short position).
Below is a chart of THHY divided by the price of HYG. A rising line indicates outperformance. The dashed line is the 5-year Treasury yield. Based on how the fund is designed, these two lines should move in sync.
Indeed, THHY has performed as advertised, outperforming an unhedged high-yield ETF such as HYG when the 5-year Treasury yield rises and falling when the interest rate falls. This makes THHY attractive as a hedge against rising interest rates, but we need to consider a new risk caused by the hedging strategy.
Hedged ETFs do not reduce total risk; they swap one risk for another. An unhedged high-yield bond fund has credit risk and interest rate risk. A high-yield ETF that hedges interest rate risk has reduced or eliminated the risk from rising interest rates (and also eliminated the gains that would accrue from falling interest rates), but it has heightened another risk: the spread between Treasury yields and junk bond yields.
The interest rate spread is the difference between high yield bond yields and Treasury bond yields on bonds with similar maturities. The spread often tightens during an economic recovery. During a recession, investors shun risk and the spread between high-yield bonds and Treasuries widens. THHY protects investors from a general rise in interest rates, when Treasury bonds, investment grade corporate bonds and junk bonds are all falling together, by shorting treasuries. If instead investors sell junk bonds for reasons other than interest rate risk, such as fears of increased bankruptcies and defaults, a hedged ETF could cost investors far more than if they held a regular unhedged junk bond fund.
The worst case scenario is a surge in credit risk as we saw in 2008. Investors piled into U.S. Treasury bonds in a flight to safety, causing spreads to widen. Investors in high-yield bonds lost money, but investors holding high-yield interest rate hedged ETFs would have been devastated because in addition to the losses on their high yield portfolio, they would have also seen large losses on the Treasury short position.
High-yield bonds ETFs that hedge interest rate risk do not offer a free lunch. What they offer is the reduction of interest rate risk, in exchange for risk of widening credit spreads. The best time to own these hedged ETFs is when the economy is strong, interest rates are rising and credit spreads are narrowing. Investors who are not expecting spreads to widen can look to high-yield interest rate hedged ETFs as way to protect against rising interest rates.
In contrast, the worst time to own them is when the economy is weak, interest rates are falling and credit spreads are widening. Investors should avoid these ETFs if they are more concerned about credit spreads than rising interest rates.
High Yield Interest Rate Hedged ETF Choices
Market Vectors High-Yield/Treasury Bond ETF. THHY has low assets of $10 million and volume is very light - on many days it trades zero shares. This makes it a poor choice for investors. The 30-day SEC yield is 4.2 percent. THHY has an expense ratio that is capped at 0.50 percent through September 1, 2014. The net expense ratio is 0.80 percent.
THHY was the best fund to introduce these ETFs because its use of the 5-year Treasury makes for an easy comparison, but ProShares High Yield-Interest Rate Hedged ETF (BATS:HYHG) is the best option for most investors thanks to its higher volume. Another big difference is that HYHG shorts the 2-, 5-, and 10-year Treasury, instead of only the 5-year. HYHG has an effective duration of 0.16, slightly lower than THHY. The 30-day SEC yield is 4.7 percent and the expense ratio, capped until September 30, 2014, is 0.50 percent. ProShares lists the gross expense ratio as 0.98 percent.
In late May of this year, iShares launched the Interest Rate Hedged High Yield Bond ETF (NYSEARCA:HYGH). Volume is still light, but it already has more than double the assets of THHY. The expense ratio is 0.55 percent with a cap that lasts through February 2016. Without the cap, expenses would be 1.15 percent. HYGH has an effective duration of 0.32 and a 30-day SEC yield of 5.65 percent.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.