Even With A Looming Rate Hike, Enthusiasm For These ETFs Wanes

In anticipation of higher U.S. interest rates, some of the largest issuers of exchange-traded funds have brought scores of interest rate hedged ETFs to market. The movement to bring these funds to market got going in earnest in 2014, and the field is now populated to the point the options number at least two dozen and several well-known issuers offer multiple interest rate hedged products.

Interest rate hedged ETFs typically pair bullish bond positions with short positions in U.S. Treasurys in an effort to lower the overall portfolio's duration. The result is lower and, in some cases, negative durations. Duration measures a bond's sensitivity to fluctuations in interest rates. Most issuers rebalance the hedges monthly to keep pace with changing market conditions.

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Potential investors should be aware that these types of zero-duration, hedged bond ETFs may underperform a non-hedged version if rates decline. Looking further out, these types of hedged-bond ETFs could provide suitable exposure to the fixed-income market in a rising interest environment, especially as the Federal Reserve plans on hiking rates sometime later this year, according to ETF Trends.

Unanticipated Reactions

With all that in mind, it would be reasonable to expect these would be go-go days for ETFs such as the ProShares High Yield Interest Rate Hedged (BATS: HYHG) and the iShares Interest Rate Hedged High Yield Bond ETF (iShares U.S. ETF Trust (NYSE:HYGH)). Recent data indicate the contrary is true.

Interestingly, the recent strong market consensus towards a US rate rise has not proven to be the boon that ETF issuers had been hoping for as interest rate hedged funds have fallen out of favour with investors in recent months. Issuers have been actively listing interest rate hedged products in anticipation of a flood of investor demand, but the demand for the products has fluctuated in recent weeks.

To this end, the four US corporate bond interest rate hedged ETFs have seen their AUM fall by a quarter from their recent highs, according to a recent Markit note.

The Fund And The Index

HYHG follows the Citi High Yield (Treasury Rate-Hedged) Index, which tracks a basket of high-yield bonds with a built-in hedge against rising interest rates. The ETF, which has a tempting 30-day SEC yield of 7.5 percent, had almost $114 million in assets under management at the end of the fourth quarter, according to ProShares data.

HYHG's effective duration is -0.22 years. The iShares Interest Rate Hedged High Yield Bond ETF holds the iShares iBoxx $ High Yid Corp Bond (ETF) (NYSE:HYG), the largest corporate junk bond ETF, with a rate hedge overlay. The $50.3 million HYGH has an effective duration of just 0.13 years, according to iShares data.

These ETFs have seen their combined AUM fall by over a third from the summers highs. This trend is driven by the deteriorating credit situation among the asset class as its spread over treasuries has surged to recent highs in the wake of the commodities collapse, according to Markit.

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