After what seems like forever, we may finally be seeing the first Federal Reserve rate hike coming our way. Since the depths of the Recession, the Federal Reserve has left benchmark interest rates at near zero in an effort to stimulate the economy. While you can debate the effectiveness of those policies till you’re blue in the face, the consequences for many investors — especially income investors — has meant stretching to find additional yield.
With certificate of deposits (CDs), money markets, and many other traditional income investments paying nothing, many investors have gone long when looking at their bonds. But there is a hidden danger when buying long bond ETFs, like iShares Barclays 20+ Yr. Treasury Bond ETF (TLT ).
That danger is duration risk.
Many investors are unaware of the problems duration can have on a bond portfolio’s value during a rising rate environment. Luckily, there are ways to stem and hedge that duration risk away.
An Inverse Relationship
Bonds and rising interest rates are like oil and vinegar — they don’t mix very well. In fact, they downright hate each other. So much so that they actually have inverse relationship. When interest rates rise, bond prices will fall. The reason for this is that as newer similar maturing bonds come to market, they’ll have higher interest/coupon rates. Bonds currently on the marketplace will drop in price to match that new yield. If you own individual bonds and plan on holding them till they mature, the drop in price isn’t as big of an issue; you’ll still get the bond’s face value back in full when it matures.
But for those investors who use bond ETFs or “pigeonholed” bond mutual funds, the problem is very real. That’s because they are constantly rolling over their portfolios of bonds to meet their mandates. As bond prices fall, so will the prices for the underlying ETFs, and that fall in prices will stick.
And for those investors who have gone out on the yield curve and plowed heavily into long bonds to gain yield, the effects will be felt even further. This is because of a force known as duration. Duration is essentially how sensitive a bond’s price is relative to interest rates, both increases and decreases. By taking in factors such as present value, yield, coupon, final maturity and bond features, you can calculate just how badly your bonds will decrease in value when Janet Yellen finally pulls the trigger on interest rates.
The real issue is that bonds with higher durations get smacked worse than shorter duration bonds. So everyone who has plowed into ETFs like the previously mentioned TLT are going to feel effects ten times stronger. For example, a bond ETF with an average duration of 2.5 years would see a 2.5% drop in price on a 1-percentage point increase in interest rates. That would drop a $1,000 initial value down to $975. However, a 12 year average duration bond would fall around 12% for the same increase in interest rates. This bond portfolio would now only be worth around $880.
Hedge Away The Risk
Given how badly duration can mess with your total returns when it comes to bond ETFs, it may be wise to look into ways to turn back the tide of the problem. One of the simplest ways is to sell long bonds — the previously mention TLT — and buy shorter ones: SPDR Lehman 1-3 Month T Bill ETF (BIL ). However, that option provides almost zero income while you wait for the Fed to actually increase interest rates.
There is a better way to hedge your duration risk.
Duration hedging basically involves shorting treasury bonds or using futures — options and other derivatives to target a much lower duration than what the portfolio actually has. The downside to this is that your yield from the hedged portfolio will be slightly less, thanks to the costs of hedging. Additionally, research from PIMCO found that your volatility could actually be greater than low-duration strategies in certain credit sectors.
Some, like ProShares Investment Grade-Interest Rate Hedged ETF (IGHG ) and Market Vectors Treasury-Hedged High Yield Bond ETF (THHY ), can get their durations down to near zero with their hedging strategies. This allows investors to take advantage of higher yields, while reducing interest rate risk down to basically nothing. However, these products hold bonds and derivatives.
A prime example for duration hedging is the Sit Rising Rate ETF (RISE ). RISE holds a portfolio consisting of futures on five and ten-year U.S. Treasury securities. The portfolio of contracts is weighted to achieve a targeted negative ten year average effective portfolio duration. This means that by buying RISE in concert with a bond portfolio, RISE will increase in value and offset the losses in the declining value of the longer dated bond holdings.
The Bottom Line
With the Fed about to raise interest rates any day now, fixed income investors better get to know duration. The measure of bond price sensitivity could be a big problem for their portfolios, especially if they have been hiding out in long-dated bonds in the current low-interest rate environment. Luckily, there are ways to hedge away that duration risk. The previous funds, along with WisdomTree Barclays U.S. Aggregate Bond Negative Duration Fund (AGND ), make ideal ways to hedge away duration risk.
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