Core eurozone bonds have had a volatile start to the year. In January, the yield on German bunds, the benchmark eurozone government bond, rose around 40 bps on the back of a relatively less dovish January ECB press conference, a higher-than-expected first tranche LTRO repayment and a relative improvement in global economic data. The sell-off was notable by historical standards as bunds recorded their worst one-month performance in ten years.

Stephen Cohen, Head of EMEA Investment Strategy and Insights Team at iShares, part of BlackRock.

Over the past few weeks, however, Europe-fuelled risk aversion has returned to markets with the spectre of political paralysis in Italy and banking crisis in Cyprus. As a result, risk assets have retraced and core government bonds have rallied sharply with bund yields coming back down to 1.27% from the recent high of 1.71% seen at the end of January.

Stephen Cohen, Head of EMEA Investment Strategy and Insights Team at iShares, the world’s largest provider of exchange-traded funds (ETFs) and a division of BlackRock, said: “Fixed income returns so far this year serve as a reminder that even small increases in rates can have a significant impact on investment-grade corporate bond returns.”

He added: “The magnitude and frequency of these swings highlights the increased volatility of this asset class. Core government yields in Europe are at historic low levels while rate volatility is increasingly elevated, particularly when compared to equities. And given the overall low level of yields in absolute terms, total returns for Euro investment grade credit are highly dependent on the performance of German rates.”

In this environment, reducing interest rate-sensitive segments of fixed income, such as longer-duration government bonds, in favour of shorter-maturity and higher credit risk segments could lead to an enhanced risk-return profile. Indeed, looking at the flows into fixed income ETFs so far this year, there has been a clear trend out of broad and long-term bond ETFs into products focusing on shorter-maturity segments. Cohen refers to this as a “duration rotation”.

Given the overall low level of yields in absolute terms, total returns for Euro-denominated investment-grade credit are highly dependent on the performance of German rates. Investors who wish to protect corporate bond portfolios from the increased volatility of German rates or wish to have isolated credit exposure can do so through a strategy that hedges interest rate risk.

According to Cohen: “Investors who wish to protect corporate bond portfolios from the increased volatility of German rates, or wish to have isolated credit exposure, can do so through an interest rate-hedged strategy. Interest rate hedging can also help to lock in past profits in existing broad corporate bond positions that were attributed to falling government bond yields.”

Several strategies are available to investors to hedge against the impact of interest rate risk during a period of rising rates, but essentially they all entail reducing the weighted-average duration of a portfolio. Reducing duration can be achieved physically by shifting a portfolio towards the short end of the yield curve by trimming positions in longer-dated bonds in favour of shorter-dated bonds, or synthetically by utilising derivative-based products, such as inverse bond ETFs, bond futures or swaps. Inverse bond ETFs, such as the db x-trackers II Eurozone Sovereigns Double Short Daily UCITS ETF (XDXE), which are essentially packaged swap products, are probably easier to deploy and make more sense for everyday investors.

An alternative, hands-off approach is to invest in a fund that includes an inbuilt interest rate hedge. iShares currently offers such a product in the form the iShares Barclays Euro Corporate Bond Interest Rate Hedged ETF (IRCP) listed on the London Stock Exchange and Deutsche Börse. This product enables investors to access corporate bonds whilst mitigating interest rate risk in a single fund. The fund, which has gathered €186 million since its launch in October 2012, protects against a potential upward shift in German yields by hedging out the interest rate risk using German government bond futures; should interest rates rise dramatically, the short position in bund futures would offset the losses arises from falling bond prices.

Other options in this space include the Nasdaq-listed First Trust High Yield Long/Short ETF (HYLS) and the NYSE Arca-listed Market Vectors Treasury-Hedged High Yield Bond ETF (THHY). For pure credit risk exposure, which takes interest rates out of the equation, investors could consider an ETF linked to the performance of a credit default swap (CDS) index, such as the db X-trackers II iTraxx Europe UCITS ETF (XTXE).