(Bloomberg) -- As the Federal Reserve prepares to raise interest rates, exchange-traded funds designed to protect bond portfolios from the fallout are likely to see big inflows.
Investors have pulled $7 billion from fixed-income ETFs as of March 12. This is a huge reversal from the $20 billion that flowed in during January and February. A positive jobs report and signs of an improving economy have investors thinking the Fed may raise rates as early as June. That would have ripple effects across the bond market as newly issued bonds become more attractive than existing bonds suddenly sporting below-market interest rates.
That's just the environment where a fairly new kind of ETF, which hedges against interest rates, should perform well. In the past six weeks, as rates have crept up, these ETFs have outperformed their plain-vanilla peers. While their assets have about tripled in the past year, to $443 million from $154 million, the products still relatively small and unknown. If and when rates rise, though, the ETFs could be the next big thing.
These products, like their currency-hedged cousins, serve up something investors want (bond exposure) while eliminating something they don’t (interest-rate risk). The ETFs effectively give retail investors access to an institutional-level product. In the past two years, 10 of them have been launched by issuers such as BlackRock, ProShares, WisdomTree, Deutsche Bank and Van Eck Global. The areas of the bond market they cover range from investment grade to high yield to emerging market debt.
What makes these funds different from regular fixed-income ETFs? They sell Treasury futures that parallel the maturities of the bonds in their portfolios. By betting against Treasury futures, the ETF gets a lift when the prices of those bonds fall, which is what happens when interest rates rise. That's how the risk of rising rates gets mitigated.
One example is the ProShares Investment Grade-Interest Rate Hedged ETF (IGHG), which owns 209 investment grade corporate bonds. The fund yields 3.5% and the bonds it holds mature, on average, in 14 years. This is pretty consistent with most investment-grade corporate bond ETFs.
Without the hedge, IGHG would suffer if rates rise. With the hedge in place, the ETF neutralizes the negative effect of rising rates on its current portfolio. It charges investors 0.30% of assets, very low for a product that's not a plain- vanilla offering. It has $112 million in assets.
There are two important things investors should understand when using interest-rate hedged ETFs. First, the ETF is on the hook to pay the coupon of the Treasury futures that they borrow to go short. Right now, that costs about 2.5% per year.
Second, investors still have the credit risk that comes with owning bonds. And if rates were to go down—an unlikely scenario at this point—and there were also concerns about bond defaults, these ETFs would be slammed.