by Tom Lydon
Tom Lydon is editor of ETFtrends.com, and president of Global Trends Investments, a registered investment adviser. He is a frequent contributor to major print, radio, and television media.
As Treasury yields move off their historic lows, financial advisers are dusting off old fixed-income hedging strategies for a rising rate environment. With the expansion of ETFs, advisers now have more options at their fingertips.
In a rising rate environment, investors need to monitor their duration and bond interest rate risk. Duration is the measure of a security’s price sensitivity to changes in interest rates, and the number provides a good sense of how much a bond’s price will decline as interest rates rise.
Bonds with larger durations have a greater interest rate risk. Fortunately for ETF investors, a number of bond-related fund products may help reduce their exposure to long-term debt.
Treasuries remain a staple of many fixed-income portfolios, and investors can hedge against rising rates by taking on Treasury bonds with shorter maturities.
The iShares 20+ Year Treasury Bond ETF (TLT) has been a popular way to provide long-term Treasury exposure, with an effective duration of 16.3 years and a 3.59 percent 30-day SEC yield. However, the fund has declined 12.8 percent over the past year as rates increased.
On the other hand, investors can consider going down the curve. The iShares 7–10 Year Treasury Bond ETF (IEF), which has a 7.46 year effective duration and a 2.11 percent 30-day SEC yield, only has declined 4.4 percent over the past year. Moving further down the line, the iShares 1–3 Year Treasury Bond ETF (SHY), which has a 1.86 year effective duration and a 0.19 percent 30-day SEC yield, actually rose 0.2 percent over the past year.
High-yield, speculative-grade junk bonds have been a popular source for yields, but the rising rates are cutting into returns. Nevertheless, the ETF industry has engineered short-duration, high-yield bonds to meet growing concerns over interest rate risk.
For example, the PIMCO 0–5 Year High Yield Corporate Bond Index ETF (HYS) has an effective duration of 2.05 years and a 3.48 percent 30-day SEC yield, and the SPDR Barclays Short Term High Yield Bond ETF (SJNK) has a 2.24 year duration and a 4.49 percent 30-day SEC yield.
Looking at the holdings, the PIMCO HYS ETF has a basket of bonds with a slightly higher credit quality, including 7.3 percent in government debt and 7.6 percent in BBB-rated debt, which is still considered investment-grade if only of lower grade.
Investors also can consider ETFs that hold floating rate notes that come with variable interest rates that help protect against rate changes.
Investment-grade floating rate ETFs include the iShares Floating Rate Note Fund (FLOT), which has an effective duration of 0.15 years and a 0.40 percent 30-day SEC yield; SPDR Barclays Capital Investment Grade Floating Rate (FLRN), which has a duration of 0.14 years and a 0.42 percent 30-day SEC yield; and Market Vectors Investment Grade Floating Rate (FLTR), which has a 0.13 year duration and a 0.62 percent 30-day SEC yield.
SPDR Blackstone/GSO Senior Loan ETF (SRLN), which resets every 77 days and comes with a 2.61 percent 30-day SEC yield, and PowerShares Senior Loan Portfolio (BKLN), which resets every 47.17 days and comes with a 3.91 percent 30-day SEC yield, provide exposure to companies that typically fall below investment-grade credit ratings, and they come with the floating rate component.
Convertibles provide exposure to the equity market and do well against other fixed-income options when rates rise. While convertible bonds do pay interest, the bonds can be converted into shares of the issuer’s common stock, making convertibles less sensitive to interest rate risk and a little more in tune with equity movements.
The SPDR Barclays Convertible Securities ETF (CWB) comes with a 2.08 percent 30-day SEC yield. The fund’s top sector allocations include technology (28.9 percent), consumer non-cyclical (17.8 percent) and finance (15.0 percent). CWB has about 40 percent of its holdings in investment-grade allocations but mostly tracks speculative-grade and non-rated quality holdings.
You don’t have to let rising interest rates weigh on clients’ fixed-income portfolios. Just take the time to dig beyond traditional asset categories.