Using Derivatives to Capture Interest Rate Spreads - Part 1

by Wayne Ferbert on February 5th, 2014

ProShares is a very successful asset management firm. They have a line of ETFs that really filled a need in the market for active traders around 7 years ago and they really took off. I believe they are now the 5th largest ETF provider by AUM.
 
They are known for ETFs used by active traders – particularly the leveraged indexes and the inverse leveraged indexes. Want to make a short-term bet that the market is heading down and want to do it with leverage? You could make that trade hypothesis a reality with their products!
 
In the last year, ProShares has moved to launch some products that expand past the active trader and to the investor with a longer-term hypothesis. One group of such products are their Interest-Rate Hedged Fixed income products. In particular, in the 2nd half of 2013 launched the IGHG and the HYHG: Investment Grade–Interest Rate Hedged ETF and the High Yield–Interest Rate Hedged ETF, respectively.
 
Basically, in each case, the fund goes long a diversified basket of the respective Fixed income (either Investment Grade or High Yield). They then use futures to create a short Treasury position of similar duration to the long fixed income portfolio. That is where the ‘Interest Rate Hedged’ position comes in.
 
As long as Treasury rates go up or down similar to the underlying fixed income interest rate, you will really have no price exposure to changes in interest rates. Instead, this product should really just be capturing the difference in the interest rate spread between the two types of fixed income represented in the ETF. In the case of the IGHG, it is the difference between the Investment Grade yield and Treasury yields. In the case of the HYHG, it is the difference between the High Yield category and the Treasury yields.
 
The managers at ProShares work behind the scenes to make sure the futures they are using represent a good match as a hedge for the underlying fixed income portfolio. For instance, they need to work to make sure the duration on the portfolio and the hedge are a good match.
 
If you are worried about a rising interest rate environment, this is a good product to utilize to hedge your price risk on bonds in that kind of environment. Obviously, with the Fed making noise about raising interest rates, these products are well timed.
 
But these products are not without risk. In particular, the risk of a credit event – or better put, a credit crisis like the one we experienced in 2008 and 2009. When the credit markets get squirrelly, fixed income investors flee products like High Yield and run to Treasuries. This will drive the price of Treasuries up and the price on High Yield and Investment Grade down. In this product, you are short Treasuries and long Hi Yield / Investment Grade. So, this event is the worst possible outcome. Not only will the fund lose value – but it will lose value in a leveraged way since you are dollar for dollar long Corporate Fixed Income and short Treasuries.
 
So, this product can be a nice product in your portfolio to capture interest spread with little to no interest rate risk – just be sure you understand the risk in a poorly performing credit market.
 
These products made us start to think: the three most followed Interest Rates in the market are Treasuries, Investment Grade Corporates, and High Yield Corporate (aka Junk bonds). Proshares has built two products that capture the spread between these 3 different interest rate categories. But what about the 3rd spread: High Yield Junk Bonds to Investment Grade Corporates.
 
ProShares has not released that product yet – and I don’t even know if they are going to. But that got me thinking, could we use derivatives to capture that spread ourselves on some of the large and very liquid ETFs that have options that cover these categories. I decided we should find out.
 
And that is Part 2 of this article – which we will publish tomorrow!



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