This analysis is by Bloomberg Intelligence analysts Dragos Ailoae and Eric Balchunas. It appeared first on the Bloomberg Terminal.
February 8, 2017
Hedged ETFs, floaters can ease rate risk as interest rates rise
The rise in interest rates, which began in July on signals that global central banks were less willing to extend accommodative policies, has gained momentum after the U.S. presidential election on potentially laxer fiscal policy by the new administration. Additionally, the Federal Reserve indicated it expects three policy-rate hikes in 2017. With the Bloomberg Barclays U.S. Corporate Bond Index duration (LUACMD) near the highest levels in decades, the management of rate risk for credit portfolios gains importance.
Several ETFs offer credit exposure but address rising rates, including interest-rate hedged ETFs and floating-rate-note funds. While such products have drawbacks, they have been proven to outperform historically.
Corporate bonds boosted by excess returns despite rising rates
Despite lower total returns for U.S. corporate bonds in 2H due to rising interest rates, excess returns — those exceeding Treasuries benchmarks — have stayed positive as credit spreads tightened. While the U.S. 10-year note’s yield climbed over 110 bps from a record-low close of 1.36% in July, credit spreads tightened 30 bps, as gauged by the Bloomberg Barclays U.S. Corporate Bond Index. Managing rate risk gains importance as the Fed moves toward monetary policy normalization, with three hikes expected in 2017.
Rate-hedged ETFs’ recent outperformance resembles 2015 rate rise
Interest-rate hedged ETFs have outperformed unhedged peers during the recent increase in yields. Hedged ETFs were similarly favored in 1H15, when yields rose 100 bps. The iShares Interest Rate Hedged Corporate Bond ETF (LQDH) beat its unhedged version (LQD) by 4.6 percentage points in that period, while the iShares Interest Rate Hedged High Yield Bond ETF (HYGH) was up 3.3% vs. 2.4% for its unhedged counterpart (HYG). Since the U.S. election, LQDH is beating LQD by 3.4 points and HYGH tops HYG by 1.9 points.
Floater ETFs provide credit exposure with lower rate risk
Floating-rate notes are another way to get U.S. high grade exposure with lower interest-rate risk. Floater coupons reset when market interest rates change, so prices of these securities fluctuate significantly less than fixed-coupon bonds with similar maturities. The iShares Floating Rate Bond ETF (FLOT) provides ETF investors with corporate high grade floater exposure and has outperformed the fixed-coupon-focused iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) by almost 5% since July 8.