Prepare Now for Looming Interest Rate Hikes

No surprise here. The Federal Reserve generated plenty of headlines Wednesday with much of that attributable to central bank's rate hike timeline now being bumped up to 2022. Oh yeah, tapering is coming, too.

Federal Reserve Chair Jerome H. Powell acted as a cooler for enthusiasm still left out there – it's been a trying September – noting the coronavirus pandemic remains an issue contend with. As a result, the Fed is dialing back economic growth and jobs gains expectations.

Informed clients likely know there's not much they can do about GDP or jobs growth, but they probably do know there are avenues for combating rising rates. This is a gold mine of opportunity for advisors because while clients likely know there tools for deal with higher borrowing costs, many aren't aware of some of the more unique strategies on this front. Advisors may want to consider getting clients up to speed on those assets sooner than later.

“Once tapering begins, the next likely catalyst for an uptick in rates across the yield curve would be an uptick in the Fed Funds rate,” says Daniel Bush of ProShares. “Keeping in mind the Fed’s dual mandate of price stability and maximum employment, let’s take a look at two potential reasons why the Fed may become more hawkish, which could lead to the next rate hike coming sooner than anticipated.”

Time to Get Hedged

In a bygone era of rate tightening, exchange traded funds issuers introduced rate-hedged ETFs, including the ProShares Investment Grade-Interest Rate Hedged (CBOE:IGHG). While these products don't wilt and die during low rate environments, they do have track records of out-performance when rates rise. That's a relevant consideration because many corporate bonds are longer duration, meaning they're vulnerable Fed hawkishness.

“For investors seeking protection from rising rates, an interest rate hedged solution may be a prudent investment,” adds Bush. “The interest rate risk embedded in the corporate bond market has risen significantly since 2013. And U.S. corporate bonds, in particular, are most likely to be negatively impacted by rising rates because of their extended duration.”

IGHG is also a relevant idea here and now because it can prove durable as tapering looms. The FTSE Corporate Investment Grade Index – IGHG's underlying index – beat the broader bond market by 5.7% during the 2013 “taper tantrum.”

While 2021 isn't 2013, the point is advisors shouldn't let clients' fixed income exposures' be overly geared to duration risk with rate hikes looming.

In hedged rate bond ETFs, the “hedges are specifically designed to reduce exposure to interest rate risk, so the strategies retain full exposure to credit risk as a primary source of return,” according to Bush.

Making Credit Bets

Some corporate bond strategies have histories of performing well against rising rate backdrops and it's no secret those assets are light on duration risk while maximizing credit risk. There's more to the story.

While the Fed can be taken at its word, it's admittedly difficult to see the central bank pushing for rate hikes in an election year and 2022 is just that.

However, IGHG protects against rising Treasury yields – a specter that could return later this year following a multi-month decline. In fact, IGHG is beating the largest corporate bond ETF by an almost 3-to-1 margin over the past year due in large part to the spike in 10-year yields that started late last year. IGHG also displayed lower volatility over that span, confirming its utility as a rising rates refuge.

Related: Why Mid Caps Are Still Marvelous