If you wanted protection from rising U.S. interest rates, would you be prepared to pay a fee equal to up to 1% of your yearly bond-fund return?
When it comes to so-called rate-hedged bond funds, it is essentially the question that investors have. These funds incorporate specialist investments in a range of interest-rate-hedging derivatives with a conventional bond portfolio. Your yearly return with a certain bond fund will be roughly equal to its yield at the time of purchase, less the cost of the hedges, if the hedges are effective.
It’s crucial to realize that these derivatives protect against both increases and decreases in interest rates, so when rates fall, rate-hedged bond funds would perform worse than nonhedged funds.
Because of this, when bond fund investors anticipate a decline in interest rates, they are less likely to purchase hedged bond funds. On the other hand, these funds seem most attractive when rates seem destined to remain higher for a longer period of time than previously believed, which is currently the case.
Hopes for a rate decrease were once again dashed when the U.S. Federal Reserve’s rate-setting committee meeting this week left interest rates unchanged. As the Fed is compelled to protect the value of the US dollar’s DXY, more and more market analysts I follow are considering the likelihood that there won’t be any rate cuts this year. Some are even raising the prospect of rate hikes.
The iShares Interest Rate Hedged Corporate Bond ETF LQDH is among the simplest examples of how rate-hedged bond funds operate. This is because this ETF is the same as the unhedged iShares iBoxx $ Investment Grade Corporate Bond ETF LQD, except for the interest-rate hedge. Therefore, the hedge will be the only cause of any variations in their returns.
The 10-year Treasury yield BX:TMUBMUSD10Y is similar to where it was a year ago, when I wrote about rate-hedged bond funds. Over the past year, the hedged ETF (LQDH) has generated a 3.9% total return, while the unhedged bond fund (LQD) has generated a 4.9% total return.
Given that the 10-year yield increased from 0.7% to its current 4.3% over this time, performance during the last five years paints a different picture. The unhedged LQD has generated an annualized loss of 0.04% during this five-year period, whereas the LQDH has generated an annualized return of 6.4%.
Ladders and hedges
Investors with shorter time horizons are best suited for rated-hedged bond funds. A bond ladder, which is a portfolio of bonds that maintains an essentially constant average duration, is a free hedge option for long-term investors. In order to accomplish this, a ladder buys a new bond with a long enough maturity each time one of its existing bonds matures. Such ladders are used by the majority of bond index funds, including the LQD ETF.
This costless hedging occurs if you keep the fund for at least one year shorter than twice its average duration, according to research published in the Financial Analysts Journal ten years ago. For instance, given the LQD fund’s current effective duration is 8.0 years, holding for at least 15 years is required. By doing so, you may be guaranteed that the fund’s present yield to maturity will produce an annualized 15-year return of nearly 5.38%.
The bottom line? Rate-hedged bond funds can be suitable for you if you have a short or intermediate investment horizon and find bond market volatility intolerable. (According to ETF.com, nine such funds are available.) Purchasing and owning a fund that invests in a bond ladder is the best option if your investment horizon is longer.
