How Interest Rate Hedged Strategies Can Help Defend Bond Portfolios
Daniel Bush, CFA®, is a senior analyst and investment strategist at ProShares.
He joined ProShares in 2018 within the investment strategy department and has more than 10 years of experience combined in asset and wealth management industries. His responsibilities include portfolio analysis, education, product research and development, and the presentation of investment strategies using the company’s strategic ETFs. Prior to joining ProShares, Mr. Bush served as a portfolio manager at BBVA USA, managing money for high-net-worth individuals, trusts and foundations. Mr. Bush earned a bachelor’s degree in finance from the Ohio State University, holds a Series 7 FINRA registration, and holds the Chartered Financial Analyst (CFA) designation.
I spoke to Daniel on October 22, 2021.
Q: With interest rates on an upward trend, how can fixed income investors brace for a negative return scenario?
A: 2021 has delivered rising rates with longer term yields rising and the yield curve steepening. The U.S. aggregate bond market has produced negative returns, and investors are looking at ways to mitigate the interest rate risk embedded in their portfolios. The ways that you can brace for that scenario typically have been by utilizing strategies that have shorter duration, i.e., less interest rate risk.
Many bond investors are going to need to look outside of traditional fixed income strategies. Over the last decade or two, bonds have generated positive returns as interest rates have continuously fallen. You've had some ups and downs during shorter time periods, but over the long term, we've been in a falling rate environment. Investors are likely going to need to look outside of the traditional fixed income choices to brace for the environment that we could see for the next couple of years.
Q: Investors who hold traditional bond ETFs may be shortening their duration in order to manage risk, but do they have other types of risks that are embedded in those strategies?
A: Two of the primary sources of risk and return within bond ETFs and bond strategies are credit and interest rate risk. If you're going to reduce interest rate risk, the standard options are shorter duration or short-term corporate bonds but these often also reduce credit risk. The credit-term premium—higher yields for longer term corporate bonds—shrinks for shorter duration corporate bonds. Longer maturity corporate bonds have more credit risk because there's more time before you receive both your coupon payments and the par value at maturity. When interest rates rise, often the economy is improving, positioning credit risk as one perhaps worth taking.
For investors who are looking for a way to capitalize on the credit risk component, ProShares offers interest rate hedged solutions. These ETFs target a duration of zero to eliminate interest rate risk while providing full exposure to the credit component of either investment grade corporate bonds with ProShares Investment Grade—Interest Rate Hedged (ticker: IGHG) or high-yield corporate bonds with ProShares High Yield—Interest Rate Hedged (HYHG). It's important to remember while high yield bonds may offer greater return potential, they also involve far greater risk, including loss of principal.
Q: Why do your funds specifically target corporate bonds rather than the broader bond market?
A: When you're looking the Bloomberg U.S. Aggregate Bond Index, corporate bonds are one of the segments with the longest duration, at about 8.7 years as of the end of the third quarter. That has significantly increased over the past several years. Compare that with the broader U.S. aggregate bond market, which has a duration of 6.7 years. Our funds offer a way for investors to cut out a slice of a diversified bond portfolio and hedge the duration-specific risk from one of the most interest rate-sensitive segments of the market. Treasuries and other government-backed securities make up a substantial portion of the broader bond market but their source of returns largely stems from interest rate risk, so the role for hedging interest rate risk may make less sense. The combination of credit risk and long duration make corporate bonds—which are roughly 25% percent of the Agg—a smart target for interest-rate hedging.
Q: What are your thoughts on Treasury bonds given your outlook for rates in general? How could things change?
A: Given our view that interest rates are likely to continue to rise, the outlook for Treasury bonds is somewhat grim. However, they can still have an important part to play within either a fixed income portfolio or a broader diversified portfolio that includes equities. If the outlook were to become bleaker and we were to see a large pullback in the equity markets or if credit spreads were to widen significantly, as we saw at the onset of the pandemic, Treasury bonds would serve as an important part of that strategy. At this time an underweight, however, may be prudent.
Q: You mentioned that ProShares’ interest rate hedged ETFs target a duration of zero. How are they constructed and how do they fit within a broader fixed income portfolio?
A: The hedges within the ETFs are constructed by taking short positions in Treasury futures contracts at three points across the yield curve to offset the duration embedded in the long-bond portfolios, either investment grade for IGHG or high yield for HYHG. They target an overall duration of zero.
As we noted, corporate bonds are about 25% of the aggregate bond index–that’s a great guide for incorporating them into fixed income portfolio.
Q: What are some of the factors putting upward pressure on interest rates?
A: There are two primary factors that drive the direction of interest rates: policy decisions made by the Federal Reserve and investor expectations of those decisions over the long term. Let’s look at the Fed and what investors are looking at with respect to how the Fed's going to make decisions. The Fed has two targets or directives: price stability and maximum employment. A lot of people have been focusing on rising inflation, so that's something that's been putting upward pressure on rates. We saw CPI come in at 5.4% as of the most recent reading in September. The Fed looks at something called “core PCE,” which reduces or eliminates some of the more volatile components of inflation in CPI. That came in at 3.6% as of the most recent reading.
But a lot of people are saying this as a transitory move with respect to inflation; however, some FOMC members have said the inflation we're seeing does seem to be extending longer than they were anticipating. A lot of it has to do with the supply bottlenecks that we're seeing here in the United States. Some of that can stem from the uneven vaccination rates across the globe, which could lead to a continued squeeze of supply chains with the delta variant leading to a further mismatch in supply and demand in the United States. Those are some concerns with the continued uptick in inflation.
The other pressure that we're seeing is a continued improvement in the labor market. Back in August, we saw the number of job openings reach all-time highs. It surpassed the number of unemployed in the United States. The unemployment rate is 4.8% and we've continued to see the Fed become a little bit more hawkish. The Fed is likely to, as it has indicated, start tapering its asset purchase program before the end of the year. The number of FOMC members who are expecting to hike the Fed funds rate next year has continued to increase. As of the latest meeting in September, half indicated that they expect to increase the Fed funds rate at least once next year. Inflation and the improving labor market have continued to make the Fed a little bit more hawkish than we had seen earlier in the year.
Q: What happens if the economy doesn't pick up as fast as expected despite these reopening efforts? What is your outlook on fixed income in that case?
A: This goes back to the question about Treasury securities and how they could play an important role within a broader diversified portfolio. If the economy doesn't pick up as fast as expected, or if unforeseen risks present themselves–it could lead to a widening of credit spreads. We could see a pullback in the stock market. I would expect Treasury securities to play an important part within a portfolio to offset credit and equity risks. But our expectations are to see a continued improvement in the economy. Economic indicators are looking strong.
Q: How high do you think rates could rise?
A: Interest rates are a multifaceted concept. We have the yield curve in general and points across it that reflect different Treasury yields. When you look at the 10-year, specifically over the last 20 years, the average has been about 3%. Now, we're at about 1.6% to 1.7%, so that average would be 1.4% above current levels.
One other thing to look at is the real yield on Treasury bonds. We don't typically see negative real yields within the Treasury market for an extended time. The real yield on the 10-year is about -0.96%. For that to get to zero, it is almost a 1% increase. I mentioned earlier that the duration of the corporate bond market is about 8.7, and that's where that concern comes with respect to the potential impact of rising rates. A 1% increase in rates across the curve could cause an 8.7% reduction in returns for a corporate bond portfolio at current rates.
Q: What is your key takeaway when it comes to the strategies that investors can use to prepare their bond portfolios for a rising rate environment?
A: Historically, the main things that investors have considered are short-duration bonds. Those typically reduce interest rate and credit risk. But they still include some amount of interest rate risk. They're short in duration, but they don't have zero duration.
Some investors also look to floating rate bonds, which eliminate most interest rate risk because they float relative to a benchmark rate and that can help with respect to mitigating the interest rate risk within a portfolio. One of the cons with those types of strategies is reduced credit exposure because they are shorter in maturity. You get reduced credit term premium and often extremely low yields.
Other strategies include the more innovative solutions, such as the interest rate hedged strategies that I brought up earlier in our conversation, like IGHG and HYHG. With respect to a rising interest rate environment, these strategies target a duration of zero, potentially eliminating interest rate risk and preserving credit risk.