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Rate-hedged bond funds appear to have won the battle but lost the war.

I’m referring to funds that hedge against rising interest rates. I’ve written about such funds before, when the prospect of higher rates—and the value of rate-hedged bond funds—was mostly theoretical. I concluded that such funds could be attractive to extremely risk-averse fixed-income investors.

The potential value of rate hedging is theoretical no more. U.S. government bonds’ first quarter loss was their worst showing since record-keeping began in 1973, and the 10-year Treasury note experienced its seventh-worst quarterly loss since the U.S. Civil War. If there ever was a time for rate-hedge bond funds to prove their value, this year is it.

To assess how they did, I will focus on the iShares Interest Rate Hedged Corporate Bond ETF LQDH, +0.16%. We know exactly how this ETF’s hedges impacted performance because an unhedged version also exists: The iShares iBoxx $ Investment Grade Corporate Bond ETF LQD, -0.11%. (Note that other rate-hedged bond ETFs also exist, but without unhedged versions that allow us to zero in on the impact of the hedges.)

Since the beginning of the year, the LQD (the unhedged version) lost 13.8% (through April 21). That’s a huge loss for an investment grade bond fund in so short a time. It is nearly double the comparable-period loss for the S&P 500 SPX, -2.77%. In contrast, the LQDH (the hedged version) lost just 3.8%. So the ETF’s hedges saved it from a 10-percentage-point loss.

That’s the good news. The bad news is that it still lost money. And it’s worth exploring why.

There are two primary reasons. Perhaps the biggest is that hedging involves a series of individual bets which may or may not work out. A bond ETF will hold a portfolio of bonds with different maturities, for example, and rates at some maturities may rise well more than those of others. This is what happens when the slope of the yield curve changes, and such changes can cause a hedge to perform poorly even when interest rates rise.

The other reason is that hedging isn’t costless; its expenses approach an annualized percentage point. So even when hedging works as designed, you nevertheless should expect to forfeit a good amount of interest income. Currently, for example, the LQD’s SEC yield is 3.80%, in contrast to 2.67% for the LQDH.

An annualized percentage point haircut in yields was a bigger deal a couple of years ago, when interest rates were a lot lower than they are today. With a current SEC yield of 2.67%, you may feel more willing to forfeit a percentage point in order to hedge against the prospect of higher rates.

Bond ladders

When in the past I have written about rate-hedged bond funds, I have mentioned another way of hedging: Buying and holding a bond ladder—a portfolio of bonds that maintains a constant average duration. (Duration is sensitivity to interest rate changes; as a general rule, bonds with longer maturities will have higher durations. Most bond mutual funds employ bond ladders.)

If you’re willing to hold a bond ladder for long enough, its total return almost certainly will be close to or equal its initial yield. The required length of time, according to the bond analysts who derived the formula, is one year less than twice the bond ladder’s duration. With a duration of 9.3 years, according to Morningstar, you therefore would need to own this ETF for 17.6 years in order that your return will match its initial yield.

That’s a long time, needless to say, though it is nevertheless consistent with the investment horizon of many retirees and near-retirees. If you don’t want to hold for that long, your choices are either to pick a bond fund with a shorter average duration (and lower yield) or go with a rate-hedged bond fund.

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 [email protected]

Source: This post first appeared on http://marketwatch.com/

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