ETFs for rising interest rates
Introduction
Many investors are concerned about the future effect on their bond portfolios of rising U.S. interest rates.
If U.S. interest rates rise over the next ten years, what will be the effect on bond returns? As a general rule, as interest rates go up, the value of most bonds goes down. This is especially true for bonds with longer terms. The market value of bonds with shorter terms are not as affected by changing interest rates.
What happens to the performance of a bond ETF in a rising interest rate environment? Obviously, the interest on any new bonds that a bond ETF purchases will probably contain a higher yield in a rising interest rate environment. Obviously, that helps the performance of the bond ETF. But the higher yield may be offset by the decrease in market value of the bond ETF's existing bonds. How quickly a bond ETF can replace its existing low interest rate bonds with higher interest rate bonds is determined by the nature of the bond index the ETF is tracking.
Strategies for rising interest rates
If you believe that U.S. interest rates will rise significantly over the next few years, you may want to consider investing in an ETF that is linked to securities that are not as affected by rising interest rates. These include:
- interest rate hedged bond ETFs
- high yield bond ETFs
- bank loan ETFs
- business development company ETFs
- inverse bond index ETFs
- stock ETFs for rising rates
- variable rate preferred stock ETFs
Interest rate hedged bond ETFs
These are bond ETFs that also hedge their interest rate exposure, typically by selling short U.S. treasury futures or U.S. treasury notes. Interest rate hedged ETFs are described further in our educational article interest rated hedged ETFs.
High yield bonds ETFs
High yield bonds are generally believed to perform better than most bonds in a rising interest rate environment. One tool we use at stoxray.com to measure the sensitivity of a bond ETF to interest rate changes is the correlation of a bond ETF to TNX, the CBOE Ten Year Treasury Note Yield Index. The average correlation to TNX of the 64 U.S. high yield bond ETFs is -0.15. A positive correlation is important, even if it is not a very strong one, because most bond ETFs have a negative correlation to TNX (as interest rates rise, the value of the bond ETF should go down).
Why are high yield bonds less affected by rising interest rates? There are really three reasons for that.
First, interest rates normally rise as the U.S. economy expands. That can be a good thing for high yield bonds because the expanding economy should generate more profits for most companies, and with increased profits, most companies can better service their debt. So in an expanding economy, default rates on high yield bonds should decline.
Second, many high yield bonds include call protection. When rates are about to rise, companies are more likely to try to take advantage of lower rates and refinance their debt before rates increase. Many high yield bonds include a call price, or pre-payment penalty, if the company refinances its debt before maturity. This pre-payment penalty adds to the returns of a high yield bond.
Third, the duration of high yield bonds is typically lower than investment grade bonds due to high yield's relatively short maturity and high coupon rates.
Click here for a list of all high yield bond ETFs
Bank loan ETFs
Bank loans should perform better than most bonds in a rising interest rate environment because bank loans generally contain floating interest rates. Most bank loans contain clauses that increase the interest rate of the loan based on a formula. But they are not a perfect hedge against rising interest rates, because many bank loans contain limits as to how much and how fast the interest rate can increase. But they are obviously less sensitive to rising interest rates than most fixed income securities. The average correlation to TNX of the 10 U.S. bank loan ETFs is -98%.
Click here for a list of all bank loan ETFs
Business development company ETFs
A business development company is a special type of closed end investment fund that makes loans to small and mid-sized businesses around the United States. There are a handful of ETFs that invest solely in BDCs. BDCs are potentially attractive to bond investors for two reasons: First, most BDCs have elected to be treated as a regulated investment company, which means that they are not taxed at a corporate level as long as they distribute at least 90% of taxable annual net income to shareholders. This means that BDCs typically have a very high dividend yield. As a result, the ETPs related to BDCs have some of the highest dividend yields of any ETPs.
Second, BDCs often make floating rate loans to businesses, which means that the typical loan portfolio of a BDC may not be as affected by rising interest rates. In fact, a BDC's income may go up as interest rates rise, as they are able to increase the average interest rate on their loan portfolio. The average correlation to TNX of the 3 BDC ETPs is 71%.
Click here for a list of all business development company ETFs
Inverse bond index ETFs
An inverse bond ETF is an ETF that uses swaps and other derivatives to intentionally move in the opposite direction of a bond index. For example, TBF, the Proshares Short 20+ Year Treasury ETF, seeks to move in the opposite direction of the Barclays U.S. 20+ Year Treasury Bond Index. But since bond indexes do not perfectly track interest rates, these inverse bond index ETFs also do not perfectly track the inverse performance of interest rates. So when you are trading shares of TBF, you are making an investment that will generally go up or down as interest rates rise or fall, but it is not a perfect "pure play".
Click here for a list of all inverse bond index ETFs.
Stock ETFs for rising rates
It is unclear whether it is possible, or practical, to build a stock portfolio using a macro economic factor like interest rates. Is it possible to build a stock portfolio made up of stocks that perform better in a rising interest rate environment? The performance of stocks is affected by so many different factors that it is unclear how important interest rates are to the performance of an individual stock. Nevertheless, there have been three stock ETFs launched that attempt to build a U.S. stock portfolio by selecting stocks that generally are less correlated to interest rates:
| Name | Symbol | Last price | Currency |
|---|---|---|---|
| ProShares Equities for Rising Rates | XNAS:EQRR | 56.38 | USD |
| INVESCO S&P 500 EX-RATE SENS | ARCX:XRLV | 53.54 | USD |
| Fidelity Dividend for Rising Rates | ARCX:FDRR | 51.41 | USD |
Variable rate preferred stock ETFs
There are a couple of ETFs that focus on variable rate preferred stocks. See VRP and PFFV. Variable rate preferred stocks are usually tied to a interest rate benchmark like LIBOR or U.S. treasuries.
ETF correlations to TNX
One simple tool that we use to analyze the sensitivity of an ETF to changing interest rates is we calculate every ETF's correlation to TNX over the lifetime of the ETF. A typical bond ETF has a negative correlation to TNX, meaning that as interest rates rise, the value of the ETF has generally fallen.
Here are the average correlations to TNX by category of U.S. Fixed Income investment funds (closed-end funds, ETFs and ETNs):
| Category2 | Category3 | Avg Correlation |
|---|---|---|
| Agency | -0.93 | |
| Bank loans | Broad market | 0.15 |
| Broad market | High yield | -0.44 |
| Broad market | Investment grade | -0.58 |
| Broad market | Socially responsible | -0.67 |
| Broad market | Unconstrained | -0.61 |
| Corporate bonds | High yield | 0.01 |
| Corporate bonds | Investment grade | -0.70 |
| Corporate bonds | Unconstrained | -0.27 |
| Emerging market bonds | -0.44 | |
| Emerging market bonds | Broad market | -0.24 |
| Emerging market bonds | Corporate | 0.01 |
| Emerging market bonds | Government | -0.34 |
| Inverse debt | High yield | 0.32 |
| Inverse debt | Treasury bond index | 0.69 |
| Leveraged debt | Corporate high yield | -0.28 |
| Leveraged debt | U.S. treasury bonds | -0.89 |
| Mortgage backed | Investment grade | -0.37 |
| Mortgage backed | Unconstrained | -0.15 |
| Municipal bonds | High yield | 0.05 |
| Municipal bonds | Investment grade | -0.28 |
| Municipal bonds | Taxable | -0.78 |
| Municipal bonds | Unconstrained | -0.34 |
| Short term bonds | -0.31 | |
| U.S. treasury bonds | Inflation-Protected | -0.68 |
| U.S. treasury bonds | Intermediate term | -0.87 |
| U.S. treasury bonds | Long term | -0.94 |
| U.S. treasury bonds | Short term | -0.39 |
| U.S. treasury bonds | STRIPS | -0.95 |
| U.S. Treasury bonds | Unconstrained | -1.00 |