Rising rates: playing defense and offense with bond ETFs

Apr 19, 2022
  • Dhruv Nagrath, CFA

2022 has thrown a lot at advisors. Positioning portfolios is hard enough when inflation is running at 40-year highs and the Federal Reserve is signalling an aggressive rate hiking cycle, its first since 2018. On top of that, Russia’s devastating invasion of Ukraine has exacerbated inflationary pressures and brought all of the macro uncertainty that is typical of such geopolitical shocks.

Though it is tempting to give up on bonds altogether and move to cash, we could risk throwing the baby out with the bathwater. That is: overlooking opportunities to better position client portfolios for the volatility ahead. Bond ETFs give advisors the tools to make portfolio adjustments with precision. With March Madness freshly in our minds, let’s take a look at possible adjustments advisors can make through the lens of defense and offense.

Defense: hedge what you’re uncertain about

There are three key adjustments that can be made to bond portfolios to play defense in the current environment: 1) hedging interest rate risk, 2) hedging inflation risk or 3) shortening portfolio duration.

1. Hedging interest rate risk

Rates have jumped higher this year as the Federal Reserve has signalled a tougher stance on monetary policy. Although there’s still debate on whether the Fed will be able to follow through, one thing is clear: interest rate volatility is a live risk. Interest rate-hedged ETFs use an efficient ‘fund of funds’ structure that seeks to mitigate interest rate risk by holding shares of a parent ETF (such as LQD) and a basket of interest rate swaps (see Figure 1). The overall result is a bond portfolio designed to have slightly lower yield and a large reduction in interest rate risk.

Figure 1: How do iShares rate hedged ETFs work?

How do iShares rate hedged ETFs work

2. Hedging inflation risk

Although markets are already pricing in higher near-term inflation expectations, it may still be prudent to partially hedge the risk that it continues to surprise to the upside. The BlackRock Investment Institute maintains a preference for inflation-linked bonds over nominal Treasuries on a tactical and a strategic horizon.

A popular solution to manage inflation risk has been TIPS ETFs, including TIP (which holds the entire inflation-indexed curve) and STIP (which holds TIPS of 0–5 year maturities). It is important to note that the return of TIPS securities is driven both by their inflation adjustment as well as their exposure to real interest rate risk. STIP would be more appropriate for investors seeking shorter duration while potentially benefiting from higher inflation.

In credit, the above-noted fund of funds structure also lends itself to inflation hedging. LQDI was the best performing iShares Bond ETF in 2022, delivering a return of 6.92% and outperforming (unhedged) LQD by 8.5% over the year. LQDH also outperformed LQD, but by ‘only’ 5% (See Figure 2).

Figure 2: Comparing LQD’s performance against rate and inflation hedged versions (rebased to 100)

Comparing LQD’s performance against rate and inflation hedged versions (rebased to 100

Source: BlackRock, Bloomberg, as of 03/31/2022. Performance data represents past performance and does not guarantee future results. Investment return and principal value will fluctuate with market conditions and may be lower or higher when you sell your shares. Current performance may differ from the performance shown. For most recent month-end performance see www.iShares.com. For standardized performance, click the following links: LQDH, LQDI, LQD

3. Shortening portfolio duration

For many investors, the goal for a bond portfolio in a rising rate environment is to reduce overall portfolio duration. iShares bond ETFs provide a range of short maturity solutions that may allow investors to adjust portfolio rate sensitivity with precision (See Figure 3).

In Treasuries, SGOV provides low-cost access to Treasuries maturing inside three months and can be used to conservatively invest cash without taking on credit risk. Within credit, IGSB and SHYG have around one-third and one-half the duration of their respective full-curve counterparts, while ICSH and NEAR offer actively managed exposure to short-term sectors. Alternatively, FLOT holds investment grade floating rate notes with coupons that rise with interest rates. The decision between fixed or floating rate corporate bonds is dependent on the Fed’s path taken in hiking rates.

Figure 3: iShares short duration solutions

iShares short duration solutions

Source: BlackRock, Bloomberg, as of 03/31/2022. Past performance does not guarantee future results. For standardized performance, including the 30-day SEC yield for these funds, click on the fund tickers above. Duration is a measure of a bond fund’s sensitivity to interest rates. For every year of duration, a 1% change in interest rates will lead to a 1% change in the opposite direction of a bond fund’s value. Effective Duration adjusts for changes in projected cash flows as a result of interest rate changes. This metric considers the likelihood that bonds will be called or prepaid before the scheduled maturity date. The ratio of the ETF’s Yield to Maturity to its Effective Duration. This measure allows comparison of how many units of yield are offered per unit of duration across ETFs. The higher the ratio, the more yield an investor is receiving per unit of interest rate risk taken on. **Net expense ratio shown for SGOV reflects contractual fee waiver in place through 06/30/2022. Gross expense ratio is 0.12%.

Offense: Yields are attractive again

Naturally in this environment, it’s more about the defense. However, one of the overlooked outcomes of this year’s moves is that pockets of the fixed income markets have rapidly repriced and look attractive again. Advisors who are comfortable adding risk or who have explicit income targets to achieve might now find attractive yields on offer in the short end of the yield curve, with the comfort that those yields now offer a healthier buffer in the event of further rate rises (See Figure 4).

Figure 4: iShares Bond ETF yields on the rise*

iShares Bond ETF yields on the rise

Source: BlackRock, as of 03/31/2022. Past performance does not guarantee future results. For standardized performance, including the 30-day SEC yield for these funds, click here. *Yields shown are yield-to-worst

Investors have also increasingly used iBonds® ETFs – which mature on set schedules – to seek to lock in specific yield levels. Advisors seeking to construct more efficient bond ladders can use this tool to consider yield curves across Treasury, Corporate, Municipal and High Income sectors.

The bottom line

There’s no denying that we face an uncertain market environment ahead and it’ll be a while before the ‘madness’ subsides. However, using the precision of iShares bond ETFs may allow advisors to better hedge rate and inflation exposure, adjust portfolio duration, and capture potential opportunities in today’s bond markets.

This information must be preceded or accompanied by a current prospectus. Investors should read and consider it carefully before investing.