Retirement Weekly: Two ways to hedge interest rate risk
Rate-hedged bond funds have performed well, and as advertised, since interest rates hit their low in the summer of 2020.
But that doesn’t necessarily mean they are a good substitute for your current bond fund holdings. There may be a better way to immunize your portfolio against the risk of rising rates.
Such a risk is omnipresent, of course. But it’s especially on retirees’ minds right now, given that the Federal Reserve’s interest-rate-setting committee decided at its meeting this week to begin tapering its quantitative easing program later this month. It simultaneously indicated that it will likely begin raising the Federal Funds rate in mid-2022.
To appreciate what rate-hedged bond funds do, it’s helpful to remember the two sources of bond market risk. The first, so-called “Duration Risk,” is the risk of higher rates; the second, so-called “Credit Risk,” is the risk that a bond’s issuer will default. What rate-hedged bond funds attempt to do is, via purchasing various interest rate futures contracts and other derivatives, eliminate the first of these two risks.
These hedges are not free, however, with costs that approach an annualized percentage point. With interest rates as low as they are currently, that percentage point represents a big chunk of your interest income. Are you willing to forego that much of your yield in order to immunize yourself against interest rate fluctuations?
To help you answer that question, take a look at the accompanying table, which focuses on the performance of the iShares Interest Rate Hedged Corporate Bond ETF
We know the impact of this fund’s hedges because an unhedged version of the ETF also exists: The iShares iBoxx $ Investment Grade Corporate Bond ETF
Annualized return since 8/4/2020 interest rate low
Annualized return since July 2016, when the Treasury’s 10-year yield was the same as today
iShares iBoxx $ Investment Grade
Corporate bond ETF (LQD)
iShares Interest Rate Hedged Corporate Bond ETF (LQDH
Notice that, since the interest rate low of August 2020, the unhedged ETF lost money—as expected. The hedged version, in contrast, turned in a very decent performance.
(As an aside, I should note that this impressive return of the hedged ETF is partly due to its hedges performing even better than expected. A number of assumptions have to be made when constructing the hedges, and so they sometimes work better or worse.)
The table also includes a column for return since July 2016, when the Treasury’s 10-year yield was the same as it is today. Also as expected, the unhedged ETF did better, since it didn’t incur the costs of the hedges. The 1.0 annualized percentage point difference in yields over this period is a good approximation of what those hedges cost.
Holding bond ladders for several years
In theory, the expected return of an interest-rate hedged fund will be its initial yield, minus the cost of the hedges. You should know, however, that there’s another way to earn that initial yield that sidesteps the need—and cost—of any hedges.
The approach involves investing in a bond ladder, which is a portfolio of bonds that maintains a constant average duration. Duration is sensitivity to interest rate changes, of course; as a general rule, bonds with longer maturities will have higher durations. Most bond mutual funds employ bond ladders.
As I discussed at some length in a recent column, your return from investing in a bond ladder will equal its starting yield provided you hold it for one year less than twice its duration. This will be true regardless of the path interest rates take along the way. Assuming you’re investing in intermediate-term bonds with, say, a five-year duration, this required holding period is perhaps tolerable. As this duration lengthens much further, however, the required holding period becomes less desirable—and you may decide that the cost of the interest-rate hedge is a worthwhile price to pay.
Consider first the iShares Core U.S. Aggregate Bond ETF
the bond ETF with the most assets under management. Its effective duration is 6.6 years, which means that your long-term annualized return will equal its current yield provided you hold it for 12.2 years (twice 6.6 minus one). That holding period is consistent with the investment horizon of many retirement portfolios.
Consider next the iShares iBoxx $ Investment Grade Corporate Bond ETF, the bond ETF for which the rated-hedged version also exists. Its average duration is 9.7 years, which means that its required holding period is 18.4 years. That may be too long for your needs.
The bottom line? While there’s an alternative to hedging, it does require long-term patience and discipline. Only you can decide whether hedging is appropriate for your financial needs and your risk aversion.
Individual bonds versus bond funds
Before I leave the subject, I need to mention—and shoot down—one other way in which some retirees think they can immunize their bondholdings from higher rates. This other way calls for investing in individual bonds and holding them to maturity. Many believe that, since they will get back their principal when the bonds mature (assuming the issuers don’t default), they will be unaffected by rising interest rates.
I devoted a Retirement Weekly column in the summer of 2020 to pointing out the flaws in this thinking, and I refer you to that column for a fuller discussion.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at email@example.com