iShares Eyes Rate-Hedged ETFs

04/18/2017 2:50 am EST

Focus: FUNDS

Mark Salzinger

Editor and Publisher, The No-Load Fund Investor

Various ETF providers offer bond ETFs that hedge away interest rate risk, leaving credit risk as essentially the only major concern about which their investors need to worry, asserts Mark Salzinger, editor of The No-Load Fund Investor.

In a period likely including fiscal stimulus from Washington, decent economic growth and slightly rising inflation, interest rates are likely to rise while credit risk declines for many companies—a perfect environment for interest-rate hedged bond ETFs. Therefore, these investments are worthy of consideration at this time.

Here’s basically how they work: the managers of the ETF devote its assets to various parts of the bond market (usually U.S. investment-grade or high-yield corporate bonds) and then hedge the portfolio’s interest rate risk away by selling enough Treasury futures to bring the duration of the entire ETF down to zero.

Investors are left with the interest from the bond portfolio, minus the cost of hedging, with virtually no risk of significant decline in net asset value if interest rates rise.

On the flip side, investors lose out on any gains that would accrue if interest rates fall; meanwhile, if interest rates fluctuate in a narrow range, investors may lose a little as compared to an unhedged portfolio because of the expense of the Treasury futures and slightly higher management fees.

iShares is a leader among ETF providers with rate-hedged bond portfolios, offering four, each of which invests in an existing iShares ETF and then hedges away its rate risk:

iShares Interest Rate Hedged Corporate Bond (LQHD) — SEC yield of 3.11%

iShares Interest  Rate Hedged 10-Plus Year Credit Bond (CLYH) — — SEC yield of 3.81%

iShares Interest Rate Hedged Emerging Markets Bond (EMBH) — SEC yield of 4.49%

iShares Interest Rate Hedged High Yield Bond (HYGH) — SEC yield of 5.55%

We note that none of the interest-rate hedged ETFs from iShares have attracted a lot of money, even though they’ve been performing well and as they should, given their designs and the interest-rate environment.

To increase the acceptance of these ETFs in the marketplace, iShares is even subsidizing their expense ratios to the degree that they are only slightly more expensive than those of their respective non-hedged equivalents.

Unfortunately, because their daily trading volumes tend to be small, bid/ask spreads can be large. Therefore, consider ‘limit’ orders on purchase for all rate-hedged ETFs.

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