Editor’s Note: This article was updated on March 8, 2021, to correct the name of the expert involved in the Q&A.
With interest rates on the rise in the current market environment, a number of different sectors are affected in a variety of way. However, one of the most impacted areas is bond funds.
As you would expect, bond funds invest mainly in bonds and are used to hopefully provide regular returns for its investors. But when interest rates jump higher, the value of bond funds fall because alternative investments start offering better returns, making them more attractive. In other words, most investors would want to wait to purchase a bond at a lower price because of these increased interest rates.
Nonetheless, not all bond funds follow this normal flow of the market environment. And two of the key securities that stand out regarding this fact are the ProShares High Yield–Interest Rate Hedged (BATS:HYHG) fund and the ProShares Investment Grade—Interest Rate Hedged ETF (BATS:IGHG).
Overall, HYHG is “a high yield corporate bond ETF with a built-in hedge that targets a duration of zero to eliminate interest rate risk.” That said, what makes an investment like this attractive to people? Well, high-yield corporate bond ETFs usually provide better return potential than other similar options because investors are taking on more risk. And while that’s true across the space, these funds at least take the question of interest rate uncertainty out of the equation. And more specifically, HYHG “combines the return potential of high yield bonds with a built-in hedge that targets a duration of zero to eliminate interest rate risk.”
Now, what exactly does a “duration of zero” mean? And why does it make HYHG an attractive choice for investors?
I had the chance to discuss this and the funds as a whole with Simeon Hyman with ProShares. And in this conversation, Hyman explains why you should consider adding HYHG or IGHG to your investment portfolio.
InvestorPlace: Can you tell me a little bit about HYHG and IGHG? What sets them apart from other bond funds? And what does it mean when information on your website says they target “a duration of zero”?
ProShares: For bond fund investors, the potential impact of interest rate movements is a key consideration. When interest rates rise, bond prices fall, and the value of a typical bond fund investment declines. The sensitivity of a bond investment to changes in interest rates is measured by duration. A portfolio with a duration of zero is hedged against rising rates.
When looking just at interest rate movements, longer duration bonds lose more money than shorter duration bonds as rates rise. That’s why many investors will shift to short term bonds if they believe interest rates will rise. But short term bonds often still have some risk exposure to rising rates. IGHG and HYHG are interest rate-hedged bond funds. They offer a diversified bond portfolio that includes a built-in hedge that targets a duration of zero to eliminate interest rate risk.
InvestorPlace: We’ve seen some upward motion in interest rates lately, which would normally scare investors away from bond funds. What makes these two funds stand strong in a situation where other bond funds may fall?
ProShares: It is often an improving economy that drives interest rates higher. Corporate bonds can outperform Treasury bonds in rising rate environments because they include an additional source of potential return—credit risk, which can be measured by credit spreads. An improving economy can bolster confidence in corporations’ ability to repay their debt, thus reducing credit spreads, and boosting the relative performance of corporate bonds. IGHG and HYHG go one step further than the typical corporate bond strategy by attempting to negate the impact of rising rates, while providing the opportunity to benefit from tightening credit spreads. The ETFs include a combination of a long portfolio of corporate bonds (investment grade for IGHG, and high yield for HYHG) with a built-in hedge to protect from rising interest rates.
InvestorPlace: What kind of investors should consider these particular bond funds? In general, bond funds are often seen as a staple for people in or close to retirement, but does a bond fund set up like IGHG and HYHG have a part to play for younger investors?
ProShares: For most investors, their overall risk tolerance would guide the allocation of stocks and bonds in their portfolio. Even a younger investor might target a 10-30% fixed income allocation, while a retiree might allocate 40% or more. IGHG and HYHG can be effective components of this fixed income allocation, particularly in rising rate environments.
InvestorPlace: The information for HYHG/IGHG specifies that indexes they follow “May not allocate more than 2% and 3% respectively to any single issuer. What does this rule do for the fund and, consequently, for investors?
ProShares: Diversification is important for both stock and portfolios and can be particularly cumbersome for investors who might be considering purchasing individual bonds. These and other related rules ensure that IGHG and HYHG hold a well-diversified and liquid portfolio of corporate bonds.
InvestorPlace: The sector makeup of IGHG and HYHG may surprise some investors. Can you share some insight?
ProShares: IGHG and HYHG’s bond portfolios are designed to reflect the composition of the broad investment grade and high yield markets respectively. That said, IGHG includes a higher allocation to the financial sector and HYHG a higher allocation to Industrials. Both sectors have historically responded well to rising interest rates and economic expansion, and have been likely contributors to the beneficial tightening of spreads in rising rate environments.
On the date of publication, Nick Clarkson did not have (either directly or indirectly) any positions in the securities mentioned in this article.
Nick Clarkson is a web editor at InvestorPlace.
In The InvestorPlace Q&A, we invite a manager to speak directly to Main Street investors, whether discussing their firm’s technologies, strategies or investments for the year ahead. Our goal is to put the spotlight on fund managers and other institutional investors of note, providing a detailed look into their management styles, world views and investing strategies. Read past interviews here.