Would you be interested in an investment grade bond fund that made money during the first quarter?
Of course you would. The first three months of this year were not kind to U.S. corporate bonds, to say the least: They suffered their second-worst quarterly loss in history, in fact. Bond investors ran for the hills in March, with the iShares iBoxx Investment Grade Corporate Bond ETF
—one of the largest ETFs benchmarked to this sector—suffering its worst monthly outflow on record.
The funds that made money despite this carnage were rate-hedged bond ETFs. These funds couple their bondholdings with derivatives that rise in value when interest rates go up. In theory, those hedges should offset the losses in the bondholdings to which the higher rates would otherwise lead.
The first quarter provided a good real-world test of this theory. Consider the iShares Interest Rate Hedged Corporate Bond ETF
which is identical to the LQD except for its interest-rate hedge. In contrast to the 5.5% loss incurred by LQD during the first quarter, LQDH gained 1.3%.
Of course, hedging doesn’t always work out this well. When interest rates are declining, for example, the hedges will constitute a significant portfolio drag. Consider the period from early November 2018 through August of last year, during which interest rates significantly declined. The 10-year Treasury yield, for example, fell during this period from over 3.2% to 0.5%.
Not surprisingly, unhedged bonds turned in an outstanding return over these 21 months. LQD produced a 16.8% annualized total return, in fact. In contrast, the hedged version of this ETF gained just 1.0% annualized.
Lagging by nearly 16 annualized percentage points is huge. That certainly sheds a different light on the rate-hedged ETF’s first-quarter performance, doesn’t it?
Should you hedge?
How, then, should you go about deciding whether to invest in a hedged or unhedged bond fund? The easy answer is that it depends on how confident you are about the direction of interest rates. If you’re sure that rates are rising, then the hedges will indeed reduce your losses.
But note carefully that the hedges aren’t free, costing about 80 basis points a year (0.8%). Is that a good deal? Since the LQD’s current yield is 2.6%, the hedges require you to forfeit about a quarter of your yield to insure against higher rates. That may strike you as expensive insurance, especially since there is another way to immunize yourself from higher rates that carries no price tag.
This other way is to invest in a bond ladder and hold it through thick and thin. A bond ladder, of course, is a portfolio of individual bonds with a fixed average duration. When one of those bonds matures, its proceeds are reinvested in another bond of sufficiently long maturity to maintain the ladder’s overall average. Most bond funds and ETFs invest in a bond ladder.
Researchers have found that provided you hold on to the ladder for one year less than twice its average duration, your total return over that entire period will almost certainly be very close to its initial yield. This formula holds true regardless of the path interest rates take along the way. It works because, during periods of rising rates, the portfolio is continually purchasing new bonds with higher yields, eventually offsetting the losses inflicted by higher rates on the portfolio’s other bonds.
For LQD, with an average duration of nine years, the required holding period would be 17 years. While that is a long time, it is well within the investment horizon of most retirees and near-retirees.
This formula puts in a new light the decision of whether or not to go with a rate-hedged bond fund. Hedging would be appropriate for those with shorter time horizons or intolerance for bonds’ risk of loss when rates rise. Otherwise not.
Also keep in mind that not all rate hedges are created equal. Hedging a portfolio requires making assumptions not only about whether rates will rise or fall, but also about the future slope of the yield curve. When that slope is different than assumed, you could lose even while getting right the overall direction of rates.
This vulnerability was very much on display in February and March of last year, during the stock market’s waterfall decline at the start of the COVID-19 pandemic. The yield curve steepened significantly as the Federal Reserve responded by forcing short-term rates down close to zero. The LQDH lost more than 20% in less than a month’s time.
That experience serves as a powerful reminder that rate-hedging doesn’t necessarily reduce volatility. In fact, the standard deviation of LQDH’s monthly returns since inception has been almost as much as LQD’s (1.72% versus 1.78%).
The bottom line? Rage hedging reduces just one kind of risk: The risk of loss when interest rates rise. You may very well find it worthwhile to hedge that risk, especially following a quarter like the first three months of this year in which the hedges paid off in a big way.
Just don’t make the mistake of thinking that the hedges eliminate all other sources of risk.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at [email protected]