Positioning For Rising Rates

Several well-respected analysts are warning that higher interest rates and lower bond prices are coming. Former Federal Reserve chairman Alan Greenspan said bond prices are in a bubble and that when rates move higher they will likely move fast. Bond king Jeffrey Gundlach of DoubleLine believes the bond bull market is over and that the 10-year yield will move toward 3 percent.  If bonds are at risk, what should fixed-income investors do?

The ProShares ETF family has an answer. They offer two interest rate hedged ETFs: High Yield-Interest Rate Hedged (HYHG) and Investment Grade-Interest Rate Hedged (IGHG). Both attempt to eliminate interest rate risk by including a built-in hedge that holds short positions in U.S. Treasury futures. 

The High Yield-Interest Rate Hedged ETF yields 5.7 percent, but that doesn’t reflect the cost of the hedge. That cost is reflected in the fund’s price. It pays monthly distributions and has an expense ratio of 0.50 percent. The Investment Grade-Interest Rate Hedged ETF yields 3.3 percent, pays monthly distributions, and has an expense ratio of 0.30 percent. 

There is a cost to the hedging. Through, November, the total return of High Yield-Interest Rate Hedged was 3.8 percent. Compare that to the unhedged SPDR High Yield Bond ETF’s (JNK) return of 6.3 percent. The hedge will be effective when interest rates rise, but until then it is a drag on portfolio returns.

There are fixed-income ETFs that can do well even as interest rates rise. One to consider is PowerShares Senior Loan Portfolio (BKLN). This fund holds floating-rate bank loans.These loans are generally made by a bank to a below investment grade company, but the rates adjust and are usually tied to LIBOR.  BKLN yields 3.3 percent.

When it comes to interest rates, readers of this column know that I’ve correctly been in the “lower for longer” camp. While the tax reform bill will put upward pressure on rates, I’m still comfortable with my fixed-income and preferred stock holdings. Rates would have to rise by more than a little to make a preferred stock that yields 6 percent unattractive. I’m not ready to switch to a hedged ETF just yet.  Still, it’s good to know these hedged products exist in case the environment changes quicker than I expect. If you believe rates will move much higher then the above mentioned ETFs are worth a closer look.