Hedging your portfolio
The chart below shows how different exchange-traded funds (or ETFs) react differently to market interest rate changes depending on their sensitivity—that is, the degree of interest rate risk associated with securities in their portfolio.
A fixed-income portfolio is composed of securities that pay a fixed return on an investment. This fixed return exposes the security and the portfolio to interest rate risk. “Interest rate risk” refers to the risk of change in real returns from an investment due to changes in interest rates. Interest rate risk affects the value of bonds more directly than stocks. As interest rates rise, bond prices fall, and vice versa. The rationale is that as interest rates increase, the opportunity cost of holding a bond decreases since investors are able to realize greater yields by switching to other investments that reflect the higher interest rate.
For example, a 5% bond is worth less if interest rates increase beyond 5%, since bondholders receive a fixed rate of return relative to the market, which is offering a higher rate of return than the bond. Consequently, the relative value of the bond declines, which translates into a dip in the bond’s price.
However, there are ways to reduce or hedge against this interest rate risk.
Floating rate securities
Floating rate securities help to hedge against declining yields in case of rising interest rates. Since these securities carry a floating interest rate, referencing a benchmark (like the London inter-bank offer rate, or LIBOR), the return on these securities rises with rising interest rates, protecting the real value of investor returns.
An effective way to use these securities is investing in ETFs. ETFs that track floating rate securities give the benefits of diversification: principal security, a compelling yield, and (most importantly), a shorter duration, which makes the ETFs less volatile to changes in the interest rate.
An investor may consider investing in leveraged loan ETFs or Treasury floating rate notes (or FRNs), depending on their risk appetite. Risk-averse investors may prefer Treasury FRNs, as they’re guaranteed by the Federal Reserve. However, the higher yields delivered by leveraged loans ETFs make them an obvious choice to the return-savvy investor.
Inverse bond funds
Inverse bond funds are ETFs designed to inverse the effect of change in market interest rates. Whereas bond prices fall when interest rates increase, inverse bond funds increase in price when interest rates increase. They essentially are the mirror image of a bond. They move up in price along with interest rates. Popular funds like the ProShares Short 20+ Year Treasury (TBF), which tracks and the iPath US Treasury 10-year Bear ETN, fall in this category.
The expense ratio for inverse funds is generally high, so investors may want to keep that in mind while investing. The expense ratio for the Active Bear ETF (HDGE), an inverse equities fund with holdings in International Business Machines Corp. (IBM) and Caterpillar Inc. (CAT), goes as high as 1.85%. This applies to bonds, too. For example, the expense ratio of the ProShares Short 20+ Year Treasury is as high as 0.95%, and for the iPath US Treasury 10-year Bear ETN, it’s 0.75%. Since expense ratio is the fee charged on your account as total annual expenses for maintaining the fund, investors may want to give it due considering before investing. The chart above shows the inverse price movements between a Treasury fund, the iShares 20+ Year Treasury Bond ETF (TLT), and the inverse bond fund, TBF.