Several well-respected analysts are warning that higher interest rates and lower bond prices are coming.
Bond king Jeffrey Gundlach of DoubleLine believes the bond bull market is over and that the 10-year yield will reach 3 percent and beyond. When it does, he expects stock prices will fall.
If bonds and stocks are at risk, what should fixed-income investors do? Here's my view.
The ProShares ETF family has an answer. They offer two interest rate hedged ETFs: High Yield–Interest Rate Hedged (HYHG) and Investment Grade-Interest Rate Hedged (IGHG). Both attempt to eliminate interest rate risk by including a built-in hedge that holds short positions in U.S. Treasury futures.
The High Yield-Interest Rate Hedged ETF yields 6.1 percent, but that doesn't reflect the cost of the hedge. That cost is reflected in the fund's price. It pays monthly distributions and has an expense ratio of 0.50 percent.
The Investment Grade-Interest Rate Hedged ETF yields 3.7 percent, pays monthly distributions, and has an expense ratio of 0.30 percent.
There is a cost to the hedging. In 2017 the total return of High Yield-Interest Rate Hedged was 3.8 percent. Compare that to the unhedged SPDR High Yield Bond ETF's (JNK) return of 6.5 percent. The hedge will be effective when interest rates rise, but until then it is a drag on portfolio returns.
There are fixed-income ETFs that can do well even as interest rates rise. One to consider is PowerShares Senior Loan Portfolio (BKLN). This fund holds floating-rate bank loans. These loans are generally made by a bank to a below investment grade company, but the rates adjust and are usually tied to LIBOR. BKLN yields 3.9 percent.
When it comes to interest rates, I'm not concerned about a sharp increase from here. While the tax reform bill put upward pressure on rates, I'm still comfortable with my fixed-income and preferred stock holdings. Rates would have to rise by more than a little to make a preferred stock that yields 6 percent unattractive.
I'm not ready to switch to a hedged ETF just yet, except for my most conservative clients. Still, it's good to know these hedged products exist in case the environment changes quicker than I expect.
If you believe rates will move much higher then the above mentioned ETFs are worth a closer look.
David Vomund is an Incline Village-based fee-only money manager. Information is found at http://www.VomundInvestments.com or by calling 775-832-8555. Clients hold the positions mentioned in this article. Past performance does not guarantee future results. Consult your financial advisor before purchasing any security.