The market has been wary of an early rate hike by the US Fed for some time now following the recent spate of robust economic readings. The jobless rate is improving steadily while the monthly nonfarm payroll data has been picking-up gradually, signaling a continuing recovery in the labor market.
The Fed is expected to maintain its current pace of tapering and wind down its assets purchase program by October. Once the money printing stops and inflation starts to take hold, the Fed will be forced to mop up the excess liquidity from the economy. But asset-sales by the Fed may not follow soon as the central bank remains anxious about a sudden rise in long-term interest rates, derailing the recovery. Minutes from the last meeting in April make no mention of such plans either.
A similar view is prevalent in the financial markets as well. James Bullard, president of the Federal Reserve Bank of St. Louis, said in a recent seminar that investors are worried about the central bank starting an asset-sales program next year. An early intervention, they fear, will cause a sudden spike in interest rates, making it difficult for consumers to make purchases on credit and companies to borrow long term.
Many analysts believe the central bank, in order to maintain its large balance sheet even after hiking short-term interest rates, would rather use new tools temporarily next year to sap excess reserves from the banking system.
Nevertheless, chances of further stimulus from the European Central Bank and the Bank of Japan to boost inflation remain a real possibility. Gauging this uncertainty, BlackRock’s iShares unit, the world’s largest issuer of exchange-traded funds, launched an actively managed corporate bond fund that features interest rate hedging strategies.
The iShares Interest Rate Hedged Corporate Bond ETF (LQDH) holds a position in the in the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) and shorts Treasury futures to hedge interest rate risks.
Fixed income investors face the challenge of adjusting interest rate sensitivity (commonly known as duration) without compromising too much on yield. A fully interest rate hedged portfolio would have a duration of zero, making them immune to interest rate shocks. Yet such a portfolio can still provide yield if combined with an unhedged position to ensure a targeted level of interest rate risk. Such investments, however, would primarily be exposed to corporate default risks as that portion of the portfolio isn’t being hedged.
By taking a position in LQD which has a duration of 7.72 years and might be considered a bit high by some investors, the newly-launched LQDH achieves a weighted average yield-to-maturity of 1.20 percent. However, the effective duration is brought down to 0.06 years, signaling negligible interest rate risks.
LQDH has an expense ratio of 0.25 percent.
Disclosure: No holdings