How rate hedging has worked so far this year

Rate-hedged bond funds seem to have won the battle but lost the war.

I am referring to funds that hedge against rising interest rates. I’ve written about these funds before, when the prospect of higher rates – and the value of rate-hedged bond funds – was mostly theoretical. I concluded that such funds could be attractive to extremely risk-averse bond investors.

The potential value of rate hedging is no longer theoretical. The first-quarter loss for US government bonds was their worst since recordkeeping began in 1973, and the 10-year Treasury note suffered its seventh-worst quarterly loss since the US Civil War. If there was ever a time for rate-hedged bond funds to prove their worth, it’s this year.

To assess how they fared, I will focus on iShares Interest Rate Hedged Corporate Bond ETF LQDH,
+0.16%.
We know exactly how this ETF’s hedges impacted performance because an unhedged version also exists: The iShares iBoxx $Investment Grade Corporate Bond ETF LQD,
-0.11%.
(Note that other rate-hedged bond ETFs also exist, but without unhedged versions that allow us to focus on the impact of hedging.)

Since the beginning of the year, the LQD (unhedged version) has lost 13.8% (through April 21). That’s a huge loss for a top-quality bond fund in such a short time. This is almost double the comparable period loss for the S&P 500 SPX,
-2.77%.
In contrast, LQDH (the hedged version) lost only 3.8%. So, ETF hedges saved it from a 10 percentage point loss.

That’s the good news. The bad news is that he still lost money. And it’s worth exploring why.

There are two main reasons. Perhaps most important is that hedging involves a series of individual bets that may or may not work. A bond ETF will hold a portfolio of bonds with different maturities, for example, and rates at some maturities can rise much more than others. This is what happens when the slope of the yield curve changes, and such changes can cause a hedge to perform poorly even when interest rates rise.

The other reason is that coverage is not free; its spending is approaching an annualized percentage point. So even when the hedge works as expected, you should still expect to lose a fair amount of interest income. Currently, for example, the SEC yield of LQD is 3.80%, compared to 2.67% for LQDH.

A one percentage point annualized discount to yields was a big deal a few years ago, when interest rates were much lower than they are today. With a current SEC yield of 2.67%, you may feel more willing to give up a percentage point to hedge against the prospect of higher rates.

Bond scales

In the past, when I wrote about rate-hedged bond funds, I mentioned another way to hedge: buy and hold a bond ladder – a portfolio of bonds that maintains a constant average duration. (Duration is the sensitivity to changes in interest rates; generally, bonds with longer maturities will have higher durations. Most bond mutual funds use bond ladders.)

If you’re willing to hold a bond ladder long enough, its total return will almost certainly be close to or equal to its initial return. The duration required, according to the bond analysts who derived the formula, is one year less than twice the duration of the bond ladder. With a duration of 9.3 years, according to Morningstar, you would therefore need to hold this ETF for 17.6 years for your return to match its initial return.

It’s long, it goes without saying, but it’s nonetheless consistent with the investment horizon of many retirees and near-retirees. If you don’t want to hold that long, you have the option of choosing a bond fund with a shorter average duration (and lower yield) or opting for a rate-hedged bond fund.

Mark Hulbert is a regular MarketWatch contributor. His Hulbert Ratings tracks investment newsletters that pay a fixed fee to be audited. He can be reached at [email protected]

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