Recommendation: Profit from rising rates with fixed income ETFs

Rising rates

For investors committed to fixed income investments, the shorter duration and higher income associated with the iShares High Yield corporate Bond ETF (HYG) and SPDR Barclays High Yield Bond ETF (JNK) may provide them with the investment return they require, with an acceptable amount of duration risk, should interest rates continue to rise modestly in the future and credit spreads not grow wider. However, investors could also consider hedging their short-term duration risk (HYG, 3.98 years, JNK, 4.20 years) with a short position in longer-dated bonds, as reflected in the below Pro Shares 20 year plus ETF (TBF).

ProShares Short 20+ Year Treasury (<a href='/quote-page/tbf/'>TBF</a>) 2014-02-18Enlarge Graph

For a detailed analysis of the U.S. macroeconomic environment supporting this series, please see Must-know 2014 US macro outlook: The crack in the debt ceiling.

Duration-neutral hedge

Should interest rates rise equally in the five-year part of the yield curve as the 20-year part of the yield curve, HYG and JNK would likely decline roughly 3.98% and 4.20% in value—ignoring any yield changes attributed to improving or worsening credit spreads—which can be significant. The iShares Barclays 20+ Year Treasury Bond ETF (TLT) would decline roughly 16.35% under similar circumstances, while its “short version” counterpart, the Pro Shares Short 20 plus year Treasury ETF (TBF), as noted in the above graph, would rise 17.49%—its effective modified duration, which tracks the Barclays 20 year plus Treasury Bond Index.

Comparing bond duration

As an approximation, the short TBF duration (17.49 years) is just over four times as great as the HYG and JNK durations of roughly 4.0 years. Investors could consider a “duration-neutral hedge” by buying 25% as much of the TBF short fund in order to offset the duration risk of the long exposure contained in other long position duration funds. That is, if an investor had $100,000 in the HYG duration at 4.0 years, he could buy 25%, or $25,000 of the TBF fund to hedge his duration risk. A 1% parallel shift in interest rates might lead to a 4% loss in $100,000 of HYG, though it would be accompanied by a 17% gain in $25,000 of TBF position. As in the above graph, the TBF ETF gained approximately 18% when interest rates rose from July 2012 through 2013. This gain on $25,000 ($4,500) would have offset the losses in HYG and JNK attributable to the rise in rates ($4,000).

It’s important to note that, as reflected in the prior graph in this series, neither HYG nor JNK declined in value during this period of rising interest rates, as improved credit spreads offset the losses due to duration related losses. Such a pattern may lead you to question the value of the “short duration” hedge against HYG and JNK, as both securities continued to grow in value during a rising rate environment. However, wouldn’t it have been nice to be up an additional 18% on 25% of the HYG or JNK position of $100,000 ($4,500, or 4.5%) as a result of hedging the lion’s share of the duration risk? Just because HYG and JNK didn’t lose value in the recent rate rise doesn’t mean that duration risk didn’t lead to a drag on the total return of HYG and JNK.

Caution: Duration hedging is an imperfect hedge

Note that duration hedging, as described above, is a highly imperfect hedge. Should an investor hedge duration risk in JNK or HYG (four-year duration) with TBF (17.5-year duration), changes in the yield curve may not be parallel or symmetrical across the curve. In other words, the level of interest rates in the five-year sector of the curve could rise or fall more than the level of interest rates in the 20-year sector of the yield curve. However, if an investor’s concerned with long rates rising aggressively as a result of future inflation expectations, while five-year rates may rise only modestly, an investor might consider hedging with the long-duration TBF proportionately, through the relative weighting of duration exposure, to their long position in HYG or JNK. However, this hedge may be less effective than anticipated if the short-term rates rose more than the long-term rates, or could incur losses if short-term rates remain unchanged and the longer-term rates associated with TBF decline.

For more information on calculating the duration of your own bond investments, see the related Market Realist series Must-know: A bond investor’s guide to duration by Surbhi Jain.

Outlook: High credit quality and longer duration (TLT & BND) versus lower credit quality and mid duration (HYG & JNK)

For fixed income investors concerned with rising interest rates and falling bond prices, long-dated (long duration) ETFs such as the iShares 20+Year Treasury Bond ETF (TLT) may continue to see price declines if interest rates continue to rise. Note that the TLT ETF has a duration of approximately 16.35 years—roughly twice that of the current ten-year Treasury bond at 8.68 years. In contrast to the long-dated TLT, the iShares iBoxx High Yield Corporate Bond ETF, HYG, has a much shorter duration of only 3.98 years, as well as exposure to improving commercial credit markets, and may continue to outperform the long duration TLT ETF in a rising rate environment.

However, investors should note that the High Yield portfolio of HYG holds roughly 90% of its portfolio in bonds rated BBB3 through B3, with roughly 10% of its portfolio in CCC-rated credit (substantial risks). HYG top holding includes Sprint Corp (S) at 0.56% of the portfolio. The Vanguard Total Bond Market ETF (BND) maintains a duration of 5.5 years, though it holds 65.4% of its portfolio in government bonds and 21% of his holdings in AAA–A rated bonds. Compared to HYG and JNK, the BND ETF is slightly longer in duration (BND 5.5 years versus HYG 3.98 and JNK 4.20). But it’s very much concentrated in government and high-quality bonds, and will therefore be less impacted by changes in the overall commercial credit markets

Lastly, for investors looking to maintain yield while gaining exposure to the commercial credit market, an alternative to the iShares HYG, the Barclays High Yield Bond Fund ETF (JNK), offers a similar duration of 4.20 years versus HYG’s 3.98 years, holding 84.17% of its portfolio in corporate industrial, 7.65% in corporate utility, and 7.5% in corporate finance-oriented bonds. Like JNK, HYG is also a big fan of Sprint Corp. (S)(0.62%) and First Data Corp. (0.44%), and it also holds CIT Group (CIT)(0.26%), Caesars Entertainment (CZR)(0.24%), T-Mobile USA (TMUS)(0.24%), Tenet Healthcare (THC)(0.24%), Ally Financial (ALLY)(0.23%), and SLM Corporation (SLM)(0.22%).