How to use ETFs to hedge against rising interest rates

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The threat of rising interest rate hikes has many advisors and clients concerned about fixed-income positions. Higher rates probably would lower bond values and bond funds’ share prices.

A traditional safety play has involved building a ladder of individual bonds with staggered maturities. Periodic redemption proceeds can be reinvested in new bonds, perhaps at higher yields.

However, using individual bonds for a ladder has its perils, including credit risk.

“There probably are some investors with ladders of GE bonds,” says Christian Magoon, CEO of Amplify ETFs. The perennially stellar GE bond issues have been among the worst fixed-income performers in 2018.

Modern maturity: One response to this potential risk is to build ladders with defined-maturity ETFs rather than individual bonds. “The defined-maturity ETF has found a place in an advisor’s toolbox. They offer diversification and convenience,” says Magoon, who helped develop defined-maturity ETFs while at a former firm.

There are two major players in defined-maturity ETFs: Invesco’s BulletShares and iShares’ iBonds, says Tom Lydon, editor and publisher of the ETF Trends website. Data from ETF Trends indicate that both sponsors offer about 20 issues in this space, with corporate, high-yield and municipal bond options available to the public. Each defined-maturity ETF holds only bonds that come due during the calendar year in the title.

To give an example, the largest such ETF, with more than $1.2 billion in assets, is BulletShares 2020 Corporate Bond ETF. This defined-maturity ETF includes over 300 issues, all of which will mature in 2020 when the fund will close. As Invesco explains, “In the final six months leading up to final maturity, bonds held within the BulletShares ETFs will mature and proceeds will be reinvested in cash and cash equivalents. … At termination [December 31 of the given year], each fund will make a cash distribution to the then-current shareholders of its net assets.

Clients can then choose to either reinvest in another perhaps higher-yielding target ETF that matures at a later date, or spend the money.

Easier does it: This format has advantages for advisors, especially when compared with the traditional alternative.

“With individual bond ladders, a great deal of capital might be needed to get adequate diversification,” Magoon says. But with defined-maturity ETFs, share prices might be around $25, so even a client with a moderate-sized portfolio could put together a ladder, holding hundreds or thousands of issues in multiple ETFs. In contrast, a wealthy client with dozens of bonds in a ladder could have more exposure to individual credits.

The ongoing laddering process, from selecting individual bonds to acquiring them, can be time consuming for advisors and expensive for clients. “Defined-maturity ETFs may be less costly,” Magoon says. Annual expense ratios range from 0.1% for corporate versions and 0.18% for municipal iBonds, to 0.42% for high yield BulletShares, ETF Trends reports.

Defined-maturity ETFs typically are rules based, Magoon continues, so there is some quality control. For instance, BulletShares ETFs invest only in bonds with a minimum $500-million issuance, and no issuer makes up more than 5% of a fund.

Fixed-income flex planning: With dates now extending as far out as 2028, a ladder of defined-maturity ETFs could make up a client’s entire fixed-income allocation. Advisors also can use them in combination with other types of bond market offerings.

“We invest in defined-maturity ETFs as part of our overall fixed-income strategy,” says Mark Bova, senior managing director and co-founder at Lenity Financial, an advisory firm in Geneva, Illinois. “These ETFs form the core of that strategy; we add other fixed income strategies around them.”

Defined-maturity ETFs are particularly important in the current rising interest-rate environment, Bova says. “We combine short-term defined-maturity ETFs with actively managed ultrashort duration fixed-income and/or investment-grade floating rate ETFs. Currently, our uses of defined-maturity ETFs include short-term, barbell and goal-driven strategies.” Generally, Bova’s defined-maturity ETFs are those dated 2018, 2019, 2020 and 2021, although he says he would go longer if indicated by economic conditions.

As an example of a goal-driven strategy, Bova explains that his clients include retirees taking required minimum distributions from retirement accounts. Such clients may hold defined-maturity ETFs for 2018, 2019, 2020, etc., inside their IRAs. As these ETFs mature each year, clients withdraw the redemption payout, which satisfies the RMD.

Other clients include retirees with annual cash-flow needs before RMDs or in excess of RMDs. If so, Bova uses defined-maturity ETFs that pay out the desired cash flow each year. “For such clients,” he says, “we also use defined-maturity ETFs in taxable accounts for income needs. We find the annual maturities as well as the monthly income to be attractive.”

Altogether, Bova says that the people at his firm are fans of these ETFs. “We can lock into an income-replacement strategy without worries of a repeat of 2008’s Great Recession or higher interest rates,” he adds. “Because of the diversification of the underlying holdings, default risk is of less concern. Defined-maturity ETFs have a reasonable yield relative to alternatives such as CDs or money market instruments.”

Lydon, who is also president of Global Trends Investments, an advisory firm in Irvine, California, agrees that defined-maturity ETFs “absolutely” can play a valuable role for advisors and their clients today.

“They could help insulate investors from the risk of rising interest rates,” he says, “adding value by providing an alternative to the troublesome task of finding and trading individual bond securities. Defined-maturity ETFs combine the advantages of ETF investing with the benefits of individual debt exposure, including the potential ability to match income with future cash-flow needs.”

Given all of their advantages, Lydon cautions that defined-maturity ETFs are meant to be buy-and-hold investments.

Rung by rung, the assured proceeds when the funds sunset can provide required distributions, desirable pocket money or dollars to reinvest at possibly higher yields in the future.

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ETFs Bonds Fixed income Retirement planning Interest rates iShares Invesco ETF Resource Center