Hedging Interest Rate Risk

hedge rising interest ratesWhen we say hedging interest rate risk, we’re referring to hedging rising interest rates. We’ve ‘enjoyed’ a 30+ year bull market in bonds which has left the current level of rates historically low. For some perspective, our Federal Funds rate was 20% in the early 1980’s-now the Fed Funds rate has been stuck at 0% for three years (officially, 0-0.25% ‘target’ according to the Federal Reserve). On the longer end of the Treasury yield curve, the U.S. 10-year Treasury bond had a low yield of approximately 1.39% in 2012 versus a yield of 16.30% in 1981. Of course, it is possible that rates in the U.S. retest this level and could even go lower, as they have in Europe.

Some European countries, viewed as safe havens, actually have negative bond yields (Switzerland, Germany, etc). That is possible here in the U.S. but probably unlikely in our opinion.

Why the Need to Hedge?

We believe that interest rates will begin rising which will have a detrimental effect on your portfolio. This prolonged decline in rates, and extended period of time with our ZIRP (zero-interest rate policy) has lulled yield-hungry investors to see low rates far into the future. The worrisome consequence is that the duration of bond portfolios (their sensitivity to interest rate movements) has become the highest ever, so if rates do rise, there will be significant losses in bond portfolios. We came across this chart below from Bloomberg via Newton Capital Management and it illustrates the sensitivity (risk) of bond movements to a 1% move in interest rates (this particular chart illustrates U.K. bond movements but U.S. bonds will move similarly). Notice the longer the maturity is, how the losses worsen. And this is just a 1% move!

Add quantitative easing from global central banks to the low interest rates and the result is a staggering amount of debt in the world, the vast majority of which will be negatively impacted by rising interest rates. Total U.S. dollar-denominated debt has inflated to over $200 trillion.

Will rates rise? No one knows for sure, but the risk is quite large if they do, especially if they overshoot on the upside for a variety of ‘reasons’. The risk/reward profile for financial securities appears quite unattractive at this point in time. When people hear about movement interest rates, they naturally think of the effect it will have on a bond portfolio, but there will certainly be ramifications for the equity (stocks) portion of your portfolio, as well. With the traditional 60/40 portfolio allocation in mind, we mention both debt and equity exposure to rising interest rates.

Hedging Rising Interest Rates for Bond Portfolios

U.S. Treasuries

There are inverse ETFs for U.S. Treasuries and various grades of corporate bonds (investment grade and high yield). One idea we find intriguing is hedging exposure to longer-term U.S. Treasury bonds. There are several inverse ETFs that hedge bond exposure and we always like to look at the ones with the most liquidity and trading volume. ProShares offers an interesting inverse ETF, the ‘Barclays Capital U.S. 20+ Treasury Index’, TBF. It aims to track the inverse of the 10 and 30 year US Treasury bonds. With over $981 million in assets and solid trading volume over 800 thousand shares (as a 3-month average) the liquidity is better than many. It is unleveraged and represents the single inverse (-1X) of the index. Also, they have swap agreements in place with seven different banks. We prefer the inverse ETFs of longer maturity (duration) bonds because of their greater sensitivity to interest rate movements.

The Need to Hedge Rising Interest Rates for Corporates

You can also hedge rising interest rates for corporate bonds. There has been an unprecedented amount of corporate bond issuance over the last few years. If you want to directly hedge investment grade corporate bond exposure with an inverse ETF there is the ProShares ‘Short Investment Grade Corporates’ (IGS) which aims to return the opposite of the Markit iBoxx $ Liquid Investment Grade Index.

What is a bit worrisome with this product, potentially, is the small amount of assets under management at only 2.9 million and low trading volume. A better option might be the ProShare’s Investment Grade Interest Rate Hedged ETF, IGHG. This is an alternative, or hedged ETF , and attempts to invest in investment grade corporate bonds while hedging out interest rate risk by simultaneously shorting U.S. Treasury bonds. IGHG has proved more popular than its bond inverse ETF counterpart (IGS) and has attracted over $166 million into the fund and almost 14 times the trading volume.

One particular area that needs hedging is corporate bond ETFs such as LQD. This product has gotten very popular, but these bonds don’t really mature in the ETF structure, making the duration, and thus sensitivity to interest rates, much higher than people expect. This could be a shoe to drop in the future.

Another idea is the iShares Floating Rate Bond ETF (FLOT). As the name implies, floating rate coupon should benefit from rising interest rates. It is also inexpensive, with just 20 basis points for an expense ratio.

Hedging Equity Exposure to Interest Rate Risk

The financial sector includes not only banks and brokerages but also REITs (real estate investment trusts), insurance companies and so-called diversified financials (private equity firms and hedge funds).

Real Estate

Financial indices have an increasing portion of their weighting in real estate exposure and more specifically, real-estate investment trusts (REITs). These trusts have become quite popular over the last few years, mostly because of their high dividend yield. They are essentially holding companies that have pooled investments in real estate. They are highly levered and their underlying assets are highly illiquid. As a group, the sector peaked 8 months before the blue chip averages in 2007 and subsequently lost over 77% of their value into the March 2009 low. Today, they appear to have peaked about 4 months prior to the major averages, but the peak is actually at a higher level than back at the peak in 2007, even though real estate hasn’t come fully back. Again, this is a testament to the voracious appetite for yield.

If interest rates rise, all these high-yielders (REITs, MLPs, BDCs, utilities) should fall since they’re considered bond equivalents. And as we know, when rates rise, bonds fall because their existing coupons (yield) are now comparatively less attractive. There is no guarantee the sector will play out this way, but we believe you should be prepared that it will. ProShares has one inverse ETF for utilities-the ‘UltraShort Utilities’ fund (SDP) which aims to return twice the opposite return of the Dow Jones U.S. Utilities Index.

Home Values

It will be increasingly difficult to obtain a mortgage at high interest rates, lowering the demand for homes and ultimately, prices. With significantly higher interest rates, the value of your home will surely fall.

If you have an adjustable rate mortgage or a line of credit, there’s a good chance its based off LIBOR. Rising LIBOR rates could trigger significantly higher monthly loan payments. You might consider locking in a fixed mortgage rate while they are historically low. If you keep adjustable rate loans, the pain of higher rates could be offset by the ETFs listed below. They include inverse ETFs, floating rate ETFs and others that specifically target interest rate sensitive sectors like business development companies, BDCs.

  • DRV
  • SRS
  • FLOT
  • TBF
  • SDP
  • BDCS
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Hedging Interest Rate Risk
The need to hedge rising interest rates is hard to imagine with rates currently so low but it will be a major investing strategy over the next few years.
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