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To hedge or not to hedge?

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Interest rate hedges cut both ways.

I’m referring to bond market strategies that protect investors from rising interest rates, which they do purchasing derivatives that make money when interest rates rise. While these hedging strategies were a boon to investors over the last couple of years as rates soared, the last several weeks serve as a powerful reminder that they detract from performance when rates fall.

There’s no free lunch when it comes to protecting yourself from interest rate fluctuations, in other words.

Consider bond returns since Oct. 24, during which the Treasury’s 10-year yield has fallen from 4.23% to its current 3.43%–a dramatic decline for so short a period of time. Bond prices have soared, with long-term Treasuries gaining more than 17% in less than two months’ time (as judged by the Vanguard Long-Term Treasury ETF
VGLT,
-0.55%
).

There’s no way of knowing for sure whether the major trend of interest rates has now turned down, or whether the last several weeks are nothing more than a countertrend dip. But rates have declined enough to make now a good time to review the performance of interest rate hedges.

The accompanying chart plots returns since Nov. 8, 2018. But for the last six months, that was when the Treasury’s 10-year yield hit its highest level of the last decade—3.23%. Rates subsequently fell to a low of 0.52% in August 2020, and then rose just as dramatically to its recent high on Oct. 24.

To illustrate the impact of interest rates hedges, the chart plots the returns of two bond ETFs. The first is the iShares Interest Rate Hedged Corporate Bond ETF
LQDH,
-0.27%,
and the other is its identical twin in all respects except that it doesn’t invest in any hedges: The iShares iBoxx Investment Grade Corporate Bond ETF
LQD,
-0.36%.
We therefore know that any differences in these ETFs’ returns must have been caused by the hedges.

Notice that in the first period covered by the chart, during which rates plunged, the unhedged ETF far outperformed the hedged one. Just the reverse was the case in the chart’s second period, during which rates soared. And then the ETFs’ relative returns reversed again in the third period, reflecting rates’ decline over the last few weeks.

These returns are hardly surprising, since it’s entirely what you’d expect given the direction of interest rates. What is perhaps more surprising are the two ETFs’ returns over the entire period since Nov. 8, 2018. Even though rates today are modestly higher than they were then, the unhedged ETF nevertheless is ahead of the hedged ETF. There are two major reasons why this is so:

  • Hedging itself carries a cost. I’ve seen various estimates of what these costs amount to, averaging from around 70 basis points per year to as much as 1%. So the hedges will be a net drag on performance even when rates rise by a small amount.

  • Hedging isn’t a perfect science. Bond funds and ETFs are constructed from a basket of hundreds of bonds of varying maturities and credit ratings, and it’s not possible to create a hedge that perfectly protects all those individual bonds from the impact of higher rates. The portfolio underlying the LQD ETF, for example, contains over a thousand individual bonds, with maturities ranging from less than 3 years to over 20 years and bond ratings ranging from AAA to BBB.

Is bond market timing the answer?

One conclusion you might be tempted to draw from this discussion is that you need to become a bond market timer, investing in unhedged bond funds when rates are in a downtrend and in hedged funds when rates are rising. While that in theory would be a very profitable strategy, you shouldn’t place too much hope on being able to predict when rates are in an uptrend or downtrends.

That’s because only a small minority of bond market timers have been able to perform even as well as a simple buy-and-hold strategy. I base this depressing conclusion on the track records of the dozens of short-term bond timers my auditing firm has tracked since the 1980s. In no five-year period did more than a tiny fraction of them keep up with even the market itself—much less beat it. The most successful five-year period was one in which just 14% of monitored timers beat a buy-and-hold. In several other five-year periods the percentage of successful bond timers was zero.

If professional bond timers are unable to do better than this, what makes you think you can consistently do better? And note that, in order to make market timing with hedged bond funds profitable, you have to have almost pinpoint accuracy. Just remember that over just the last seven weeks long-term Treasuries have rallied more than 17%.

The conclusion I draw is that we have no idea whether interest rates in a year’s time will be higher or lower than they are now. Though many Wall Street gurus are confidently predicting what they think will happen, you should ignore them. As I argued last week, these market prognosticators are often wrong but never in doubt.

The bottom line? Your choice between an unhedged and a hedged bond fund comes down to your tolerance for volatility and risk. Hedging reduces volatility, since it reduces the number and magnitude of otherwise large gains or losses. But that hedging comes with a cost.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com.

Credit: marketwatch.com

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