Rising Rates Series: Interest Rate Hedged ETFs

In her final article of the series, Karen explains how ETFs make sophisticated interest rate swaps accessible to all investors.

As interest rates continue to rise, many investors are thinking about ways to help protect the value of their bond portfolios. In this rising rates series, we have considered options such as short-maturity and floating rate bonds and bond ladders. Another way to combat rising rates is to outright hedge the value of interest rates using an interest rate swap.

Interest rate swaps, a type of financial derivative, are essentially an agreement by multiple parties to exchange streams of future bond interest payments (usually fixed and floating rates). That’s all well and good, but the average person just doesn’t have the means to access these instruments, which often require documentation from the International Swaps and Derivatives Association (ISDA), capital requirements and specialized trading knowledge.

So what’s a savvy bond investor to do?

Enter the interest rate hedged exchange traded fund (ETF), which provides investors with exposure to a bond portfolio plus a hedge. So if you have a view that rates will rise across the yield curve but still want to hold corporate or emerging market bonds, an interest rate hedged ETF will allow you to express that view. These bonds might also offer more income than floating rate or short-maturity bonds, as they provide exposure to issues that are farther out on the yield curve. (Longer-maturity bonds typically yield more than their shorter counterparts.)

How Interest Rate Hedged ETFs work

iShares’ suite of ETFs is set up like a fund-of-funds (or ETF-of-ETFs). Each ETF holds shares of a parent ETF plus a basket of interest rate swaps. The swaps are issued at specific “tenors” (the time left on the contract)—such as  two, five,10 and 30 years—that correspond with the interest rate risk, or duration, of the underlying bonds in the portfolios.

Let’s compare interest rate hedged bonds with unhedged and shorter-maturity bonds. Corporate bonds have exposure to both credit risk and interest rate risk; the shorter-maturity bond typically has a lower level of these risk factors.  As shown below, interest rate swaps help mitigate the impact of interest rates while retaining exposure to credit risk.

corpBond Illustration

For illustrative purposes only.

The cost of hedging

An interest rate hedged ETF distributes bond income of the bonds less the cost of the hedge, so there is an impact. The chart below shows how the 30-day SEC yields of various iShares ETFs compare. Note that the yield on the iShares Interest Rate Hedged Corporate Bond ETF (LQDH) is lower than that of its parent, the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD); that’s primarily due to the “yield” or cost of being short interest rates via the swaps. Yet it’s still higher than the short-maturity and floating rate ETFs.

Corporate bondFInal1

Source: BlackRock as of 8/21/2018. Funds referenced are: the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD); the iShares Interest Rate Hedged Corporate Bond ETF (LQDH); iShares 0-5 Year Investment Grade Corporate Bond ETF (SLQD); iShares Floating Rate Bond ETF (FLOT); iBonds Ladder is represented by an equal weighting of the following funds: iShares iBonds® Dec 2018 Term Corporate ETF (IBDH), iShares iBonds® Dec 2019 Term Corporate ETF (IBDK), iShares iBonds® Dec 2020 Term Corporate ETF (IBDL), iShares iBonds® Dec 2021 Term Corporate ETF (IBDM), iShares iBonds® Dec 2022 Term Corporate ETF (IBDN), iShares iBonds® Dec 2023 Term Corporate ETF (IBDO), iShares iBonds® Dec 2024 Term Corporate ETF (IBDP), iShares iBonds® Dec 2025 Term Corporate ETF (IBDQ), iShares iBonds® Dec 2026 Term Corporate ETF (IBDR) and iShares iBonds® Dec 2027 Term Corporate ETF (IBDS). Past performance does not guarantee future results. For standardized performance, please click on the tickers.

Performance in different environments

In addition to impacting the yield, hedging will also affect a bond’s total return, which includes any changes in its market price. Here, there is good news: When rates are rising, interest rate hedged ETFs have tended to outperform their non-hedged parents.

Let’s look at price changes over a four-year period that encompassed both rising and falling interest rates. Between May 2014 and February 2016, 10-year Treasury yields declined from 2.64% to 1.73%, according to Bloomberg; during that time, LQD outperformed its hedged version, LQDH. But when 10-year Treasury yields increased from 1.73% to 2.96% (through July 2018), LQDH outperformed, even accounting for the cost of hedging. It’s worth noting that over the past year ending 7/31/18, as 10-year Treasury yields increased 0.67% to 2.96%, LQDH did notably better. Performance will depend on the changes in both interest rates and credit spreads over the time period.corporate

Source: BlackRock as of 7/31/2018.  Falling rates period was from May 2014 to February 2016.  Rising rates period was from Feb 2016 to July 2018.  One year was ending 7/31/2018. Past performance does not guarantee future results. For standardized performance, please click on the tickers.

Hedging interest rates doesn’t have to be complicated if you have the tools. iShares interest rate hedged ETFs can help investors express a view on rates and credit—conveniently and at low cost.

Karen Schenone, CFA, is a Fixed Income Product Strategist within BlackRock’s Global Fixed Income Group and a regular contributor to The Blog.

The performance quoted represents past performance and does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when sold or redeemed, may be worth more or less than the original cost. Current performance may be lower or higher than the performance quoted. Performance data current to the most recent month end may be obtained by visiting www.iShares.com or www.blackrock.com.

Carefully consider the Funds’ investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds’ prospectuses or, if available, the summary prospectuses which may be obtained by visiting www.iShares.com or www.blackrock.com. Read the prospectus carefully before investing.

Investing involves risk, including possible loss of principal.

Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments.

Actively managed funds do not seek to replicate the performance of a specified index. Actively managed funds may have higher portfolio turnover than index funds.

Investing in long/short strategies presents the opportunity for significant losses, including the loss of your total investment. Such strategies have the potential for heightened volatility and in general, are not suitable for all investors.

A fund’s use of derivatives may reduce a fund’s returns and/or increase volatility and subject the fund to counterparty risk, which is the risk that the other party in the transaction will not fulfill its contractual obligation. A fund could suffer losses related to its derivative positions because of a possible lack of liquidity in the secondary market and as a result of unanticipated market movements, which losses are potentially unlimited.  There can be no assurance that any fund’s hedging transactions will be effective.

There is no guarantee that interest rate risk will be reduced or eliminated within the Fund.

Investment in a fund of funds is subject to the risks and expenses of the underlying funds.

Shares of ETFs trade at market price, which may be greater or less than net asset value. The iShares® iBonds® ETFs (“Funds”) will terminate within the month and year in each Fund’s name. An investment in the Fund(s) is not guaranteed, and an investor may experience losses and/or tax consequences, including near or at the termination date. In the final months of each Fund’s operation, its portfolio will transition to cash and cash-like instruments. As a result, its yield will tend to move toward prevailing money market rates, and may be lower than the yields of the bonds previously held by the Fund and lower than prevailing yields in the bond market.

Securities with floating or variable interest rates may decline in value if their coupon rates do not keep pace with comparable market interest rates. The Fund’s income may decline when interest rates fall because most of the debt instruments held by the Fund will have floating or variable rates.

An investment in the Fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency and its return and yield will fluctuate with market conditions.

Buying and selling shares of ETFs will result in brokerage commissions.

The Funds are distributed by BlackRock Investments, LLC (together with its affiliates, “BlackRock”).

The iShares Funds are not sponsored, endorsed, issued, sold or promoted by Markit Indices Limited, nor does this company make any representation regarding the advisability of investing in the Funds. BlackRock is not affiliated with Markit Indices Limited. This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of September 2018 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

This document contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial advisor before making an investment decision.

©2018 BlackRock. iBONDS, iSHARES and BLACKROCK are registered trademarks of BlackRock. All other marks are the property of their respective owners.