How Lack of Duration in Bond Can Bring you Down
Exchange-traded funds which hedge out US bond duration are growing in popularity, with total assets in the biggest portfolios nearly doubling this year to about $2 billion.
The chart below illustrates 4 of the biggest duration hedged ETFs:
- iShares Interest Rate Hedged Corporate Bond ETF (LQDH) | Year-to-date return: 1.29%
- iShares Interest Rate Hedged High Yield Bond ETF (HYGH) | Year-to-date return: 4.06%
- ProShares Investment Grade-Interest Rate Hedged ETF (IGHG) | Year-to-date return: -0.19%
- WisdomTree Interest Rate Hedged High Yield Bond Fund (HYZD) | Year-to-date return: 2.67%
that attracted inflows as follows:
The popularity is driven by the fact that as interest rate go up, bond price will fall which would result in negative returns when investing in bond. However, if one were to hedging out the bond duration, i.e. negative duration, it could instead generate a positive return – proven for US Bonds, where as of 2018-08-01, all four duration hedged ETF outperformed Barclays Global Aggregate Bond Index (LEGATRUU), with year-to-date of -1.95%.
Ashis Dash, an associate director at Morningstar Inc., said in an interview in late June that while a large number of funds have adopted the flexibility to go negative duration in the past decade, the risks are so high that most will only chose to use it tactically for very short periods of time.
Gershon Distenfeld, co-head of Fixed Income of AllianceBernstein, argues that duration-hedged approaches can only outperform in the kind of late cycle environment markets are currently enjoying. Yet there are already signs growth may be fragile: In the euro zone, expansion is sputtering with at least a year still to go before rate liftoff by the European Central Bank.
When the cycle ends and higher rates start to slow growth, the losses will mount very quickly, Distenfeld said. By his calculations, an investor who hedged duration in a U.S. high yield fund going into the 2008 financial crisis — basically a worst case scenario — would have posted losses exceeding 34%.
“You’re paying away a lot of carry to be short duration. It’s expensive, the timing is critical,” Distenfeld said. “History shows that very few people, if any, are able to time what’s going to happen to yields.”
Reference:
Bloomberg, Natasha Doff, 2018-08-01, “‘You’re Going to Lose Money.’ $270 Billion Investor’s Bond Worry”
