Using ETFs to hedge interest rate risk

What is interest rate risk?

Depending on what type of asset you're holding (usually stocks vs. bonds), interest rate risk can have different definitions and implications:

1. For bonds: Bond yields rise and fall with interest rates, and bond prices are inversely related to the former. Putting it together when rates rise, bond yields soar, and bond prices fall. The opposite happens when rates are cut. Bond duration governs the sensitivity of a bond's yield (and therefore price) with respect to changes in interest rates. The longer duration a bond has, the more sensitive it is.
2. For stocks: An increase in interest rates means an increase in the cost of capital for companies, all else being equal. A higher interest rate causes future earnings to be discounted more, and also decreases investment and spending on margin by companies, which reduces their present valuation (share price). 

Hedging interest rate risk

My preferred way to hedge interest rate risk as a retail investor is to simply do nothing. This is because I have time on my side and a high-risk tolerance. Because I will not need to withdraw from my portfolio for another couple of decades, I can "ride out" rate changes under the assumption that over time, we will see many rate hikes and cuts. Interest rates are also more or less "priced in" ahead of time into asset prices via market expectations, which makes for a difficult market timing exercise. 

However, for investors with a lower risk tolerance or in retirement, interest rate risk can be devastating. Case in point, consider the retiree with a 60% bond allocation in an aggregate bond fund with an intermediate duration of 8 years. If rates rose 1%, that bond allocation would be expected to drop by around 8%. Stock-bond correlations also tend to turn positive during rising rate environments, which negates much of the diversification benefit provided by bonds. 

The simplest way to mitigate (but not hedge) interest rate risk is via an allocation to short duration bonds with a maturity of 1-5 years, or ultra-short duration T-Bills with a maturity of 0-3 months. These assets won't lose as much (or at all for T-Bills) when rates rise. However, they pay poor yields (inflation is now a risk) and conversely won't gain much if rates get cut. Some options include:

• Vanguard Short-Term Treasury ETF (VGSH): -3.36% YTD. 
• iShares 0-3 Month Treasury Bond ETF (SGOV): +0.07% YTD. 

Investors can also short intermediate or long-term Treasurys which have a higher sensitivity to rate changes and thus lose more value during a rising rate environment. Instead of using options or futures, a leveraged inverse ETF might work. These funds use swaps to achieve daily, leveraged inverse exposure to a bond index benchmark. The keyword here is "daily" – the math of how compounding works make their long-term returns vary wildly from the daily target. This makes these funds more appropriate as a short-term, tactical holding. 

• Direxion Daily 7-10 Year Treasury Bear 3X Shares ETF (TYO): +26.15% YTD.
• Direxion Daily 20 Year Plus Treasury Bear 3X Shares ETF (TMV): +69.26% YTD.

Finally, advanced investors can make use of more complex funds that use over-the-counter (OTC) derivatives that provide convex exposure to interest rate volatility. A great example is the Simplify Interest Rate Hedge ETF (PFIX),  which provides a risk/return profile similar to holding long-dated put options on 20-year U.S. Treasurys. The ETF is up 34.15% YTD. 

Please note this article is for information purposes only and does not constitute investment advice.