Fear of rising rates can sow the seeds of bad behaviour

Since its March 2011 launch, investors, on average, haven't been very successful in using BKLN to shield themselves against the effects of rising rates. The fund's cash-flow-weighted return from its inception through March 2018 was about negative 1.6%. Meanwhile its time-weighted return was 3.1%. The difference is, in part, evidence of poor timing decisions.

One such instance of bad timing occurred as chatter of a rate hike intensified in 2015. That March, the Federal Open Market Committee in the United States stated that "labor market conditions have improved further, with strong job gains and a lower unemployment rate." Investors believed this was one of many signs pointing to an imminent lift-off. That April, BKLN raked in US$300 million of inflows. Unfortunately for those investors who poured money into BKLN in anticipation of a rate hike, the FOMC's April statement struck a different tone, noting that economic growth had slowed during the winter months. Furthermore, soon after the FOMC's April press release, senior loan investors got caught up in the high-yield sell-off that was instigated by plummeting energy prices. During the months that followed, BKLN saw its value decline and investors headed for the exits.

Of course, the Fed ultimately did raise rates near the end of 2015. This episode illustrates not only how difficult it is to predict changes in rates, but also the countless factors -- energy prices in this case -- that may influence this (or any) fund's performance. All these factors are simply impossible to forecast. Equally important, it highlights another piece of evidence indicting investors as their own worst enemies.

However, it does not necessarily mean investors are doomed in the face of interest-rate risk. Though difficult, it may still be prudent to manage this risk. Following are some instruments that may help mitigate the effects of rate increases on investors' fixed-income portfolios.

Cash

Cash is the mother of all hedges. The most conservative approach for investors concerned about interest-rate risk is to liquidate some of their fixed-income holdings and raise cash. While cash takes all interest-rate risk out of the equation, it has notable weaknesses. Most importantly, after moving into cash investors must decide when to redeploy it. Raising cash and then putting it back to work in such fashion is effectively market-timing. Uncertainty, one of the risks that the investor sought to avoid by raising cash in the first place, comes back into the equation when they look to put it back to work. This simple solution is not free either. Whether selling current positions at a gain or loss, there will be transaction costs. Also, investors can incur capital gain taxes by selling at a gain. Finally, cash currently offers practically no return. In fact, cash will earn a negative real return in today's rate environment.

Short-term bonds

Short-term bond ETFs typically offer higher yields than cash and provide a low-cost path to dial back interest-rate risk.  iShares Core Canadian Short Term Bond ETF (XSB), which sports a 0.17% expense ratio, and  Vanguard Canadian Short-Term Bond ETF (VSB), which charges a 0.11% fee, are among the cheapest and safest ETF options. Both funds earn Morningstar Analyst Ratings of Silver. However, drawbacks applicable to cash -- including transaction costs for selling existing holdings and buying new short-term bond ETFs, tax considerations and market-timing risk -- apply to short-term bonds as well. In addition, though better than cash, XSB and VSB currently have zero real yields.

There are higher-yielding short-term bond ETFs, though they assume additional credit risk. Specifically, investors might consider Vanguard Canadian Short-Term Corporate Bond Index ETF (VSC) or BMO Short Corporate Bond Index ETF (ZCS), both of which charge a 0.11% fee. Both funds track indexes that invest in investment-grade corporate bonds with maturities of less than five years. However, their yields are barely above the inflation rate.

While index-tracking ETFs offer advantages such as low costs and tax efficiency, they are, well, passively managed. These "hands-off" vehicles pose a few challenges. Because the composition of their portfolios is largely dictated by debt capital market activities, they steer toward to the most active part of the yield curve and/or sector they aim to track. Accordingly, these funds can have concentrated positions on points in the yield curve that leave them more susceptible to losses when rates rise.

Interest-rate hedged bond ETFs

These solutions are not yet available on the Canadian market, so investors will have to shop in the U.S. if this is something they are interested in. Like a typical bond ETF, interest-rate hedged bond ETFs track an index. However, the funds employ rate-hedging mechanisms -- such as shorting Treasury futures -- to all but eliminate the fund's interest-rate risk.  IShares Interest Rate Hedged Corporate Bond ETF (LQDH) (expense ratio: 0.24%) takes a long position in its sister investment-grade corporate bond ETF,  iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD and a short position in interest-rate swaps. ProShares Investment Grade—Interest Rate Hedged IGHG (expense ratio: 0.30%) offers exposure to U.S. dollar-denominated investment-grade debt and uses Treasury futures to target a zero duration. Arguably, these ETFs can achieve the objective of reducing duration risk while maintaining credit exposure. Both funds have been around only for a few years, but they have been successful in hedging interest-rate risk, maintaining a duration close to zero.

While these funds do reduce interest-rate risk, they tend to behave like stocks. In fact, their monthly return correlation with the S&P 500 Index from June 2014 to March 2018 was 0.65. Investors tend to hold bonds to diversify equity, as bonds tend to go up when stocks go down, and vice versa. However, these rate-hedged ETFs diminish the diversification benefit of bonds, as exemplified by their greater correlations to stocks versus their unhedged counterparts. Also, these funds may be costly to trade, given their small asset bases and low trading volume.

Conclusion

None of the various rate-hedging strategies I've described here is particularly easy to implement in a low-cost manner. Each comes with its own caveats. The most important of those warnings being that history has proven that market-timing is impossible. While it is important to understand the broad array of tools for combatting interest-rate risk, the best weapon for defending one's portfolio might be time. As rates rise, investors and the funds they own will reinvest dividends, coupon payments and the proceeds of any maturities at the prevailing -- and presumably higher -- rates.