The Federal Reserve is under constant watch with market participants attempting to predict the timing of the next increase in the Federal funds rate. When the hike does occur there will undoubtedly be a significant impact on asset prices around the world, most notably a direct decrease in the value of fixed income exchange-traded funds. This is due to the inverse relationship between interest rates and bond prices.
Investors should prepare for yield curve twists as well as shifts, warns ProShares.
Duration is commonly used to measure interest rate risk. However, the measure does suffer from a limitation as it guides the investor to the size of a fall in bond prices for a uniform upwards shift of interest rates at all points along the yield curve, which is historically unlikely.
ProShares, a US-based ETF provider best known for their short and leveraged products, highlighted in a recent research paper how interest rates seldom tend to move uniformly when base Federal rates are changed. Indeed, the yield curve which measures the yields on bonds of various maturities, may shift upwards or downwards, flatten or steepen its slope, twist or even invert.
ProShares illustrates the notion that rates may move unexpectedly along the yield curve by referencing two examples from recent history. Firstly, following the 1998 Russian Debt Crisis and collapse of Long Term Capital Management, the Fed funds rate was lowered 175bps to 4.00%, however, 10-year Treasury yields actually increased from 4.42% to 5.78%.
More recently, during the period April 1st to June 26th, the yields on 10-year Treasury Bonds rose by 62 bps to 2.47% however, there had been no change in Federal Reserve rates. Indeed, market expectation for a future rate increase actually declined during this period. Investors with a bond portfolio possessing a duration of 10 years or longer would have lost over 6% value from their holdings.
Due to the possibility of unexpected changes in the shape of the yield curve, ProShares provide two ETFs that track diversified bond portfolios but also mitigate any interest rate risk: the ProShares Investment Grade Interest Rate Hedged ETF (IGHG) or the Proshares High Yield Interest Rate Hedged ETF (HYHG). These funds perform this hedge by holding short positions in the Treasury futures market, with contracts spaced along the yield curve to better withstand the effects of twists and changing gradients.
For example, if the bonds within the ETF have a weighted-average duration of 4.5 years, the ETF would hold a combination of short positions in the Treasury futures market targeting 2-year, 5-year and 10-year Treasury notes, resulting in an off-setting weighted average duration of -4.5 years. Further to this, the fund will weight their exposure to the short positions according to where most of the duration risk of the bonds arise on the yield curve. This allows the funds to better cope with adverse movements in the yield curve, such as twists or changing gradients. These ETFs rebalance their hedges monthly to keep pace with changing bond market conditions.
About the funds
The ProShares Investment Grade Interest Rate Hedged ETF (IGHG) trades on the BATS Exchange in US dollars. The fund offers exposure to US investment grade fixed income instruments while mitigating interest rate risk through use of short positions on the Treasury futures market. There are over 140 separate issuers and exposure to any one issuer is capped at 3%. There is a current weighted-average yield to maturity of 4.1% and a weighted-average coupon of 4.9%. Through the use of short positions on the Treasury futures market, current effective duration is negligible. There is current sector exposure to financials (33.3%), industrial-services (19.4%) and industrial manufacturing (18.7%). The fund has a total expense ratio of 0.3%.
The Proshares High Yield Interest Rate Hedged ETF (HYHG) also trades on the BATS Exchange in US dollars. The fund offers exposure to high-yield income securities of firms which are domiciled in the US or Canada while mitigating interest rate risk through short positions on the Treasury futures market. There are over 120 different issuers within the portfolio and exposure to any one issuer is capped at 2%. There is a weighted-average maturity of 6.4 years, a weighted-average coupon of 6.7% and an effective duration, after hedging, of -0.1 years. The fund has current sector exposure to industrial-services (37.4%), industrial-manufacturing (26.8%) and industrial-energy (16.2%). The fund has a total expense ratio of 0.5%.