Fixed Income, Fixed Income, Currency & Alternative, Interest Rate Strategies

Bundling Rising Rate Strategies with Exchange-Traded Funds

by Rick Harper, Head of Fixed Income & Currency and Bradley Krom, Fixed Income & Currency, on October 7, 2014

In our view, exchange-traded funds (ETFs) can provide powerful tools for fixed income investors both big and small. Even some of the most sophisticated investment managers have used ETFs to gain broad-based exposure to certain subsets of the fixed income market. This is perhaps most applicable in high-yield and emerging market debt. ETFs allow investors a way to efficiently access a basket of bonds as opposed to attempting to buy or sell each security on its own. With this same approach in mind, WisdomTree has sought to bundle institutional-caliber strategies to mitigate interest rate risk in an easy-to-access ETF wrapper. As highlighted below, the mechanics of these approaches seek to address the risk of rising rates head on.

One common concern about traditional approaches to rising rates is that the portfolios’ underlying investment characteristics change in the name of trying to reduce risk. By altering the coupon type or shifting to the very front of the yield curve, investors must change their portfolio’s DNA. In our approach to rising rates, we have sought to maintain traditional bond exposures while modifying exposure to interest rate risk. In doing so, we sought to create portfolios that investors are familiar with and that provide them with the risk management tools they seek.

The Barclays U.S. Aggregate Index is the most recognized fixed income index in the world, with over $4 trillion in assets benchmarked to it.1 In partnering with BofA Merrill Lynch, we were able to access a commonly followed investment strategy of high-yield bonds maturing within five years. However, in a rising rate environment, both investment-grade and high-yield bonds are likely to underperform. In response, we sought to create two different risk profiles for each strategy:
• Zero duration indexes, which seek to offset the interest rate exposure in the long bond portfolio
• Negative duration indexes, whereby the overlay strategy is constructed to target a duration below zero, creating an index that could potentially benefit from a rising rate environment
In both approaches, investors are given the flexibility to mitigate interest rate risk in the same way that they currently manage credit risk via ETFs. On the day the Federal Reserve (Fed) began tapering its asset purchase program, WisdomTree launched the Barclays U.S. Aggregate Bond Zero Duration Fund (AGZD), the Barclays U.S. Aggregate Bond Negative Duration Fund (AGND), the BofA Merrill Lynch High Yield Bond Zero Duration Fund (HYZD)and the BofA Merrill Lynch High Yield Bond Negative Duration Fund (HYND) to help investors maintain bond exposure while mitigating risk. As a result, the performance impact of the Fed’s shift in policy can be easily observed through the performance of these strategies.

Interest Rate Risk Is More Than a Number

While some investors seek to quantify interest rate risk via a single duration number, it is important to note that interest rates seldom move in parallel shifts across the yield curve. As illustrated below, traditional fixed income strategies have a large percentage of their exposure to securities at the short end of the yield curve. In the case of the Barclays U.S. Aggregate Index, over 80% of the portfolio falls within the 0–5-year duration bucket.2
Barclays U.S. Aggregate Index

In constructing our rising rate strategies, we first identify the sensitivities of the long portfolio to interest rate risk. As part of this process, the sensitivities are quantified. Then a mirror image of interest rate exposures is constructed within the hedge to help immunize the bond positions from fluctuations in rates.

In the case of the negative duration strategies, these portfolios “overhedge” their long exposure through selling longer duration securities to target the desired exposure without leverage. As shown in the table below, the primary difference between zero and negative duration strategies is the concentration of short positions at the longer end of the yield curve.
Duration Statistics and Breakouts for “Rising Rate” Indexes

For definitions of indexes in the chart, please visit our glossary.

While the timing of changes in Fed policy remains uncertain, we believe that ETFs provide an important tool for helping to manage interest rate risk. Through our approach, we allow investors to maintain their existing bond exposure while mitigating their overall exposure to interest rate risk.

1Source: Barclays, as of 12/31/13.
2Source: Barclays, as of 8/31/14.

Important Risks Related to this Article

There are risks associated with investing, including possible loss of principal. Non-investment-grade debt securities (also known as high-yield or “junk” bonds) have lower credit ratings and involve a greater risk to principal. Fixed income investments are subject to interest rate risk; their value will normally decline as interest rates rise. The duration Funds seek to mitigate interest rate risk by taking short positions in U.S. Treasuries, but there is no guarantee this will be achieved. Derivative investments can be volatile, and these investments may be less liquid than other securities, and more sensitive to the effects of varied economic conditions. Fixed income investments are also subject to credit risk, the risk that the issuer of a bond will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline. The duration Funds may engage in “short sale” transactions of U.S. Treasuries, where losses may be exaggerated, potentially losing more money than the actual cost of the investment, and the third party to the short sale may fail to honor its contract terms, causing a loss to the duration Funds. While the duration Funds attempt to limit credit and counterparty exposure, the value of an investment in the duration Funds may change quickly and without warning in response to issuer or counterparty defaults and changes in the credit ratings of each Fund’s portfolio investments. Investors should anticipate that due to the negative duration target, those Funds will be highly sensitive to interest rate changes. The higher (whether positive or negative) a bond fund’s duration, the greater its sensitivity to interest rates changes, and fluctuations in value, whether positive or negative, will be more pronounced. Investing in mortgage- and asset-backed securities involves interest rate, credit, valuation, extension and liquidity risks and the risk that payments on the underlying assets are delayed, prepaid, subordinated or defaulted on. Due to the investment strategy of certain funds, they may make higher capital gain distributions than other ETFs. Securities with floating rates can be less sensitive to interest rate changes than securities with fixed interest rates, but they may decline in value. The issuance of floating rate notes by the U.S. Treasury is new and the amount of supply will be limited. Fixed income securities will normally decline in value as interest rates rise. The value of an investment in the Fund may change quickly and without warning in response to issuer or counterparty defaults and changes in the credit ratings of the Fund’s portfolio investments. Please read each Fund’s prospectus for specific details regarding each Fund’s risk profile. Barclays Capital Inc. and its affiliates (“Barclays”) are not the issuer or producer of the Funds, and Barclays has no responsibilities, obligations or duties to investors in the Funds. These Barclays Indexes are a trademark owned by Barclays Bank PLC and licensed for use by WisdomTree with respect to the WisdomTree trust as the issuer of the Funds. Barclays’ only relationship with WisdomTree is the licensing of these Barclays Indexes, which is determined, composed and calculated by Barclays without regard to WisdomTree or the Funds. While WisdomTree may for itself execute transaction(s) with Barclays in or relating to these Barclays Indexes in connection with the Funds that investors acquire from WisdomTree, investors in the Funds neither acquire any interest in these Barclays Indexes nor enter into any relationship of any kind whatsoever with Barclays upon making an investment in the Funds. 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