ETF providers position funds for rising interest rate environment

NEW YORK Tue Sep 24, 2013 2:30pm EDT

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NEW YORK (Reuters) - Exchange-traded fund companies are coming to market with a rash of new products and strategies designed to protect income investors from the dangers of rising interest rates.

Even though the Federal Reserve deferred the start of a rising rate era when it held policy steady last week, "the narrative still holds," said Matt Tucker, head of fixed income strategy at BlackRock's iShares.

Investors still expect interest rates to rise when the central bank starts to reduce its bond-buying in the months to come, Tucker said.

When interest rates rise, bonds and bond funds tend to lose value, a fact that has caused investors to pull out of many traditional bond funds this year.

From the beginning of June, when Fed-tightening rumors started to circulate, investors have withdrawn $123.4 billion from bond funds through Friday, September 20, according to data from research provider TrimTabs. Outflows of $68.6 billion in June were the biggest for any month on TrimTabs' records.

To keep those investors happy and keep their assets, BlackRock and others are unveiling and promoting exchange-traded funds (ETFs) that focus on bonds but rely on protective strategies like interest rate hedging and defined-maturity portfolios.

Guggenheim Investments on Tuesday introduced two new High Yield Corporate Bond ETFs to its BulletShares lineup of fixed-maturity ETFs. BlackRock's iShares launched its first corporate bond defined-maturity ETF suite in April, and added another four defined-maturity ETFs in July.

BlackRock, the largest ETF provider, also has plans to launch a new iShares fund focused on short maturity bonds, according to a company filing with the Securities and Exchange Commission. The ETF is set to trade under the ticker "NEAR" on the BATS Exchange when it launches, according to the filing.

The introduction of new products comes on the back of what ETF providers say is an increasing investor appetite for such funds. Year to date, investors have put $31.6 billion into short-term exchange-traded bond funds as they are less volatile when rates rise than long-term bond funds, according to BlackRock.

In addition, investors have been putting money into exchange-traded products like BlackRock's iShares Floating Rate Bond ETF, which aims to reduce interest rate risk by focusing on bonds whose coupon payments change based on prevailing short-term interest rates. It has had roughly $2.9 billion in net inflows since January, according to data from IndexUniverse.

DEFINED MATURITY

Rising rates cause falling bond prices, and the longer the maturity of the bond, the sharper the fall. For every 1 percent increase in interest rates, the price of a 10-year Treasury bond can be expected to decline roughly 8.7 percent. Holders of individual bonds can avoid selling at a loss by simply holding the bonds to maturity, when they can cash in their bonds for their full initial value.

Bond fund investors have no fixed maturity date to target. Their fund portfolios buy and sell bonds but investors never know when their stake will return to its initial value.

They can lose money in ETFs, too, of course. ETFs, which are traded all day on stock exchanges, can see more volatility than traditional mutual funds (which only price once a day, after the markets close.) And ETFs track indexes, so a straight bond ETF can be as risky as a traditional bond mutual fund when rates rise.

ETF producers are finding ways, however, to create and track indexes that employ more complicated strategies than traditional bond funds do.

For example, Guggenheim Investments is positioning its BulletShares ETFs as ideally situated for a rising rate environment. The BulletShares funds are bond funds which each aim at a different maturity date. For example, the Guggenheim BulletShares 2015 High Yield Corporate ETF, focuses on investment-grade corporate bonds that mature in 2015.

Guggenheim has 10 traditional corporate bond BulletShares ETFs and eight high yield corporate bond BulletShares ETFs, including the two new ETFs that began trading on Tuesday.

Investors can buy several of these BulletShares and know that the principal they have invested in each one will be there in full when the fund matures. In that way they can set up their own "laddered" portfolios - with some money coming due every year and some money earning the higher yields that longer-term bonds and funds command.

The 2015 fund has won $218 million in net inflows so far this year, according to IndexUniverse data.

Guggenheim, which launched its first corporate bond BulletShares ETF in 2010, had record sales For its BulletShares suite in July, according to Bill Belden, head of product development and managing director, who expects inflows to continue apace as investors seek to protect against rising rates.

RATE HEDGING

Other ETF providers have introduced products that use hedging strategies to limit rising rate risks. Van Eck launched its Market Vector Treasury-Hedged High Yield Bond ETF in late March. The ETF provides exposure to high yield corporate bonds and takes short positions in Treasury notes to hedge against rising interest rates.

At ProShares, which launched a similar High Yield - Interest Rate Hedged ETF in May, "We had a lot of our adviser and client community come and ask what they could do to protect their bond portfolios in a rising rate environment," said Stephen Sachs, head of capital markets at ProShares.

ETF providers say they also expect this year's significant inflows into short-term bond ETFs to continue. Those funds, like Vanguard Short-Term Corporate Bond Index, PIMCO's 0-5 Year High Yield Corporate Bond ETF, the iShares 1-3 Year Credit Bond ETF and the SPDR Barclays Short Term High Yield Bond ETF, are less responsive to interest rate hikes than long-term funds.

(In 19th paragraph, adds Belden's first name and title)

(Reporting by Ashley Lau; Editing by Linda Stern and Andrew Hay)

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