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.

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