ETF strategies for a rising rate environment

January 18, 2022

Last year was a phenomenal one for capital markets. With stock markets reaching new highs and the increased probability of the pandemic’s transformation into an endemic, the future looks bright. The Covid omicron variant stoked some investors’ fears, and the emergence of new variants will likely lead to a spike in bearish headlines every now and then. Recently, however, the market has been shaking off the bad news about the virus, leading to decline in the number of market reversals attributed to virus pessimism. Going forward, we should again start to analyze fundamental economic theory, supply and demand ideology, and major financial concepts to structure our portfolio, as we once did in a pre-Covid world.

The beginning of the year is always an exciting time as investment strategists, economists, and widely-followed institutions place their bets and predictions for the year. Some of the best ideas and top investment themes for 2022 have already been featured by major media outlets. One of the top investment themes to emerge for this year is the challenge of investing in a rising rate environment. Exchange-traded funds (ETFs) may provide investors with a low-cost way to gain exposure to the fixed-income space in this challenging rate environment.

As inflation rates rise to record highs around the world, central banks are increasingly signalling more hawkish policy decisions to come, in an effort to put inflation in check. Market consensus appears to be coalescing around the probability of three rate hikes this year, by both the U.S. Federal Reserve and the Bank of Canada. In anticipation, traders have sold off government bonds, steadily raising yields. This upward momentum in yields can have drastic consequences on portfolios. Chart 1 illustrates how Treasury-bill rates in Canada evolved in 2021.

Typically, bonds tend to lag in a rising-rate environment, as prices move inversely to yields. One way investors have successfully navigated this dilemma is by using floating-rate structures. Taken individually, this is a complex asset class and is a challenge for individual retail investors to research, trade, and manage. Fortunately, there is a wide array of Canadian floating-rate ETFs available to choose from. Table 1 list some floating-rate ETFs that may be poised to outperform as rates creep upwards.

There are some key distinctions to be made for this list. When interest rates are rising, it is best to shorten portfolio duration. Both XFR (duration of 0.17 years as of Jan. 10, 2022) and PFL (duration of 0.08 as of Nov. 30, 2021) are lower-risk funds, with 3-year avearge annual standard deviation at 0.3166 as of Nov. 30, 2021, well below the median 1.8017 for the category.

CAFR and DXV invest primarily in investment-grade securities. Both ETFs seek to mitigate the effects of interest rate fluctuations through the use of interest-rate derivatives. These are very stable, low risk funds whose mandate is not primarily chasing return from rising rates, but instead looking to mitigate the downside associated with any change in the prevailing rate structure, whether up or down.

Investment-grade bonds are generally more susceptible to interest rate risk, while high-yield instruments are more exposed to credit risk. A hike in interest rates is generally a signal that central banks are confident of economic prosperity, and hence credit spreads tend to tighten initially. This is beneficial for high-yield bonds.

High-yield bonds are actually more similar to equity than their investment-grade counterparts. Senior loans are usually linked to a reference rate that resets when rates change. Senior loans also take precedence over high-yield and equity in payback priority in the case of default. High yield products are relatively the riskiest, but also have potential for outperformance. In Table 1, ZFH, MFT, and IFRF are all rated low to medium risk.

In prior periods of rising rates, low unemployment rates, higher-than-average inflation, and powerful stock market rallies, high-yield credit has usually outperformed high-grade corporates and government Treasuries. High yield credit could therefore help add some alpha while mitigating interest rate risk arising from the floating rate component in a portfolio.

Looking to equities

Fixed-income ETFs like these are one way to help mitigate risk and improve returns in a rising interest rate environment. But there are also equity-based solutions available. For example, Fidelity Canada offers its Fidelity U.S. Dividend Rising Rates ETF (TSX: FCRR). Launched in 2018, it has a mandate to invest primarily in dividend-paying shares of U.S. companies that have a positive correlation of returns to rising 10-year U.S. Treasury yields. With an MER of 0.39%, medium risk, and a medium-to-long time horizon, FCRR aims for outperformance during a period of rising interest rates.

Investing in banks and financial services firms that are poised to earn higher interest income from higher interest rates may be another way to mitigage rate risk. The Hamilton Enhanced Canadian Bank ETF (TSX: HCAL), for example, is an alternative fund, offering 1.25 times leveraged exposure to Canadian banks.

Precious metals also tend to do well in high inflation environments, and are used tactically as a hedge against it. But as central banks work to tamp down inflation and the hedge is wound down, there may be some weakness in this asset class.

Currency play

Lastly, all hail the mighty dollar. History has shown us that in times of rising rates, the U.S. dollar gains momentum due to increased capital inflows. An easy way to exploit this opportunity is through ETFs. If you are investing in a Canadian dollar denominated ETF that invests primarily in U.S. dollar-denominated securities, look for an unhedged version of the fund, as it could possibly gain some alpha due to the appreciation of the underlying U.S. dollar holdings. Or you might look for a U.S. dollar-denominated version of the strategy. Canadian ETF providers offer a wide range of unhedged, hedged, and U.S. dollar-denominated strategies to better suit investor needs in a changing environment.

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