Using ETFs To Measure Interest Rate Risk

by on May 17, 2012 | ETFs Mentioned:

When managing a fixed income portfolio, there are two primary risk factors that financial advisors consider: credit risk and interest rate risk. The superstar bond fund managers of the world have set themselves apart by a superior ability to identify these risk components–and then select securities that offer superior risk-adjusted returns [see also Better-Than-AGG Total Bond Market Portfolio].

The first risk factor is easy enough to understand; the more likely an issuer of debt is to default and leave bondholders with nothing, the greater the return that will be demanded by those lending money. Companies and countries with stellar credit ratings and strong cash flow profiles can borrow funds at relatively low rates of interest, while more speculative issuers will have ot pay significantly more in interest to compensate for the additional credit risk. Disparities in credit risk explain why Wells Fargo can issue debt with a 3.75% coupon, while less stable companies such as First Data are issuing debt with coupons of about 12.6%. Many fixed income managers devote significant portions of time attempting to identify disparities between the interest companies are paying on debt and their actual credit risk; figuring out a disconnect can result in an opportunity to generate alpha.

Interest Rate Risk & ETFs

The other risk factor that affects fixed income investments isn’t quite as sexy as default rates and credit downgrades. But it’s no less important; managing interest rate risk effectively is often the difference between sub-par and exceptional returns  [see also Bond ETFs That Steer Clear Of Interest Rate Risk].

Increases in interest rates generally lead to lower valuations for bonds; because new securities will be issued with higher yields than they previously were, the appeal of debt already outstanding is diminished somewhat. Suppose you’re holding a bond paying 5% annually, and the Fed raises rates by 1%. Suddenly, a bond with the same credit risk components as the one you hold is being issued with a 6% coupon–meaning that your bond is less attractive to potential buyers [see also Bond ETFs For Every Objective].

There are, of course, ETFs that fall in every corner of the credit risk / interest rate risk spectrum. Investors have tools for fine tuning their risk / return profiles, as the current ETF lineup includes everything from money market funds to ultra high yield debt.

Case Study: Risk vs. Return

The lineup of BulletShares ETFs from Guggenheim can be used to illustrate just how the trade-off between interest rate risk and yield generally works. The BulletShares products are unique from most other fixed income funds in that each product focuses on investment grade corporate debt maturing in a certain year (there is also a suite of BulletShares ETFs targeting high yield corporate bonds). While the credit profiles are not identical, they are generally similar in that component bonds are deemed to be “investment grade” by major credit agencies [see also Hitchhiker's Guide To The ETF Galaxy] .

As shown below, sliding along the maturity spectrum results in incremental expected yield–measured here by the standardized 30-day SEC yield measure. Each step into the future also beings increased sensitivity to interest rate changes; as the duration lengthens, so too generally does the sensitivity of the fund price to changes in market interest rates:

Ticker Maturity 30 Day SEC Yield Average Duration
BSCC 2012 0.77% 0.42
BSCD 2013 0.94% 1.16
BSCE 2014 1.32% 2.09
BSCF 2015 1.72% 2.97
BSCG 2016 1.99% 3.81
BSCH 2017 2.55% 4.56
BSCI 2018 2.73% 5.06
BSCJ 2019 3.03% 5.66
BSCK 2020 3.18% n/a
Yield as of 5/11, Duration as of 3/31

Taking on additional interest rate risk by extending the effective duration can result in material increases to the expected yield; BSCK, which targets corporate debt maturing in 2020, has a 30-day SEC yield that exceeds that of BSCC by almost 250 basis points. That potential return, of course, comes with higher risk [see also High Yield ETFdb Portfolio].

In addition to being useful as tools for planning future obligations–such as four years of college tuition starting in 2017–BulletShares can also be used to fine tune interest rate exposure for those with sophisticated views on movements of the yield curve.

Disclosure: No positions at time of writing.