How to Preserve Credit Opportunities While Eliminating Rate Risk

One of the nifty things about exchange traded funds is that there’s seemingly an ETF for every occasion, including rising interest rates.

Obviously, that’s the scenario advisors and clients are contending with today and they’ll be dealing with it over the course of this year and likely 2023 as well. As advisors well know, the problems rising interest rates present aren’t confined to declining bond prices. The issue is much deeper because the conventional way of dealing with rising interest rates – embracing lower duration bonds – usually means taking on lower yields.

That’s the traditional tradeoff – lower rate risk leads to a reduce income profile while higher rate or credit risk means higher yields. Problem is even with interest rates rising, yields on high-quality bonds are still low, putting a burden on advisors to source income in a rising rate climate.

An avenue for doing just that is with rate-hedged bonds ETFs, including the ProShares High Yield—Interest Rate Hedged ETF (HYHG) and the ProShares Investment Grade-Interest Rate Hedged (CBOE:IGHG).

Make Credit Call with Rate Protection

The rub with ETFs such as IGHG and HYHG is that they’re likely to lose value when interest rates are declining. Clearly, the opposite is at play today.

A simple way of conveying to clients what these products do is elimination of rate risk while maintaining some exposure to credit opportunities so that income is generate. Think of it as a best of both worlds approach for the current climate. These funds are also ideal ways to capitalize on credit spreads as rates rise.

“Because companies often thrive in a booming economy, investors don’t demand as much of a premium for investing in corporate bonds when growth accelerates,” according to ProShares research. “Credit spreads – that is, the difference in the interest rates between corporate bonds and Treasurys – can shrink. In fact, credit spreads for both investment-grade and high-yield bonds have been negatively correlated with interest rates.”

History confirms that corporate bonds often top Treasuries as rates rise because contracting credit spreads augment some of the risk incurred by way of soaring government bond yields. Underscoring the utility of IGHG in particular, is the fact that many traditional investment-grade corporate bond funds carry longer duration, meaning they too are vulnerable to rising rates.

Translation: It’s hard to defeat rate risk while maintain adequate exposure to credit opportunities. HYHG and IGHG ease that burden.

Fixing the Problem

As noted over the course this piece, it’s a daunting task to lower duration risk and keep income at a decent level.

“That runs counter to the common assumption that short-duration or floating-rate strategies provide the best protection in a rising rate environment,” concludes ProShares. “These strategies do reduce interest rate risk, but they also limit credit exposure. They may help dampen the negative effects of rising rates but at the cost of limiting the opportunity to profit from credit spreads. Interest rate hedged bond strategies are structured to virtually eliminate interest rate risk while retaining full exposure to credit risk. It’s a combination that may be well-suited to a rising interest rate environment.”

Bottom line: It’s not a hopeless time for bond investors. It’s simply a matter of identifying the right strategies and steering clear of high-grade, rate-sensitive fare.

Related: Call on Convertible Bonds for Rising Rates Protection