MW These bond funds shield you from interest-rate shocks - but here's the catch

By Mark Hulbert

Insurance against Fed rate hikes with 'rate-hedged' ETFs doesn't come cheap

Would you be willing to pay a fee of up to 1% of your annual bond-fund return to gain protection against rising U.S. interest rates?

That, in essence, is the question that investors face with so-called rate-hedged bond funds. These funds combine a standard portfolio of bonds with specialized investments in various derivatives that hedge against interest-rate fluctuations. To the extent those hedges work, your annual return with a particular bond fund will be about equal to its yield when you purchase it, minus the cost of the hedges.

It's important to understand that these derivatives hedge against both interest-rate declines as well as increases, so rate-hedged bond funds will underperform nonhedged funds when rates decline.

This is why few bond-fund investors buy hedged bond funds when they think interest rates will fall. In contrast, these funds look most appealing when rates appear destined to be higher for longer than previously thought - as is now the case.

The U.S. Federal Reserve's rate-setting committee meeting this week kept interest rates unchanged, once again dashing hopes for a rate cut. Market analysts I follow increasingly are entertaining the possibility that there will be no rate cuts at all this year, and some are even mentioning the possibility of rate hikes as the Fed is forced to defend the U.S. dollar's DXY value.

One of the most straightforward illustrations of how rate-hedged bond funds work is the iShares Interest Rate Hedged Corporate Bond ETF LQDH. That's because, but for the interest-rate hedge, this ETF is identical to the unhedged iShares iBoxx $ Investment Grade Corporate Bond ETF LQD. So any differences in their returns will trace solely to the hedge.

I wrote about rate-hedged bond funds a year ago, and the 10-year Treasury yield BX:TMUBMUSD10Y today is close to where it stood then. The unhedged bond fund $(LQD)$ has produced a 4.9% total return over this past year, versus 3.9% for the hedged ETF $(LQDH.UK)$.

Performance over the past five years tells a different story, since the 10-year yield over this period has climbed from 0.7% to its current 4.3%. Over this five-year period, the unhedged LQD has produced a 0.04% annualized loss, versus a 6.4% annualized gain for the LQDH.

Hedges and ladders

Rated-hedged bond funds are most appropriate for shorter-term investors. If you're investing long-term, you can hedge for free with a so-called bond ladder - a bond portfolio that maintains, more or less, a basically constant average duration. A ladder does this by purchasing a new bond of sufficient maturity whenever one of its previously held bonds matures. Most bond index funds, including the LQD ETF, use such ladders.

According to research that appeared a decade ago in the Financial Analysts Journal, this costless hedge exists provided that you hold the fund at least as long as one year less than twice its average duration. For example, in the case of the LQD fund, that means holding for at least 15 years, since its current effective duration is 8.0 years. If you do that, you are assured of an annualized 15-year return of close to 5.38%, the fund's current yield to maturity.

The bottom line? If your investment horizon is short or intermediate term, and you find bond-market volatility intolerable, then rate-hedged bond funds may be appropriate for you. (ETF.com reports that there are nine such funds available.) If your investment horizon instead is longer term, buying and holding a fund that invests in a bond ladder is the way to go.

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 mark@hulbertratings.com.

More: Sitting on cash? Lock in this new Series I bond rate to protect your savings from inflation.

Plus: How to pick dividend stocks positioned to keep growing dividends

-Mark Hulbert

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