New ETF Offers Protection Against Rising Rates

NEW YORK (TheStreet) -- The bond market is becoming increasingly difficult to navigate as any positive economic news lead to fears that the Federal Reserve will start reducing its monthly asset purchases -- the so-called tapering -- causing bond prices to fall and interest rates to rise, and which is what happened last Friday when employment data was released.

The new Pro Shares Investment Grade Interest Rate Hedged ETF (IGHG) is the latest fund trying to offer protection against rising rates, but is the first fund to protect an investment grade portfolio. Like other hedged bond funds, IGHG has two portfolios side-by-side: The investment grade bond portfolio and a combination of short positions in various U.S. treasury futures contracts.

The bond portfolio component of the fund is a very simple, investment grade corporate portfolio. It is well diversified with 457 holdings of both domestic and foreign bonds; the foreign bonds are dollar denominated.

The sector breakdown favors financials at 32%, followed by industrial-service at 20% and industrial-manufacturing at 17%. The sector makeup is generally in line with more mainstream corporate bond ETFs likes the iShares iBoxx Investment Grade Corporate Bond ETF (LQD).

The current weighted average maturity of the portfolio is just under 15 years. The hedge strategy will target the same maturity as the bond portfolio and, for now, that is done with 55% short 10-year futures, 33% short 30-year futures and 12% in the Pro Shares Ultra Short 20+ Year Treasury ETF (TBT).

It's too early for any specific yield information for the fund, but the fact sheet notes the average coupon in the fund is at 5.13%, and that the average price for the bonds in the portfolio is $107.62 which gives a rough estimated yield of 4.76% for the index. Subtracting the 0.30% expense ratio for the fund could put the yield near 4.46%. However, there will likely be a drag from the cost of maintaining the hedge against rising interest that could further reduce the yield.

Another risk factor is that interest rates could go back down. That is not a prediction so much as an acknowledgement that interest rates went far lower than most people expected in the face of unprecedented Fed policy -- one which is likely to remain in place for several years.

If rates did go back to their lows, then the short positions in the fund would be adversely affected. This may not cause the fund's price to drop because the bond portfolio should somehow go up in price. However in that scenario, at the very least, the fund would not keep up with unhedged funds.

There is a key point of understanding which is after years of record low interest rates, there will come a time where interest rates normalize and they could over-compensate by swinging to levels higher than normal.

If/When this happens the dislocation in the bond market and the funds that invest in bonds could massive. As a rule of thumb for each one percent that a ten year bond moves up in yield, the price is likely to fall 8%. If 10-year yields go from 2, 3 or 4% -- depending on the type of bond -- up to 5, 6 or 7% the portfolio impact for investors could catastrophic.

Individual bonds have a par value to return to but bond funds don't, they could go down and stay down. It seems unlikely that this will happen soon because it is clear the Fed is at least a couple of years from raising the rate it controls but the Fed has no direct control over the rest of the yield curve.

There will be more hedged bond ETFs created and while they probably will have a role when interest rates do rise, it is important to remember that for now these funds have not been tested yet. They are intended to hedge against rising interest rates but there can be no guarantees of doing so successfully.

At the time of publication, the author held no positions in any of the stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

If you liked this article you might like

Bond Market Selloff Can Be Profitable if You Use the Right ETF

Bond Market Selloff Can Be Profitable if You Use the Right ETF

ProShares Investment GradeInterest Rate Hedged (IGHG) Enters Oversold Territory

ProShares Investment GradeInterest Rate Hedged (IGHG) Enters Oversold Territory

7 ETFs That Take Advantage of the Fed Stimulus Pullback

7 ETFs That Take Advantage of the Fed Stimulus Pullback

ProShares Bond ETFs Offer Fix for Rising Rate Fears

ProShares Bond ETFs Offer Fix for Rising Rate Fears