3 Bond ETFs That Didn't Get The Rate Hike Boost Many Expected

A full month has now passed since the Federal Reserve hiked interest rates for the first time since 2006. This development created a far different environment than many investors anticipated. In fact, many of the funds that were considered at the top of a rate hike “play book” need to be reconsidered in light of current market trends.

Let’s examine some of the foremost rate hike plays that have been touted since the taper tantrum of 2013.

ProShares Short 20+ Year Treasury Bond ETF TBF

Most investors automatically associate rising interest rates with falling Treasury bond prices. Therefore, a fund like TBF, which shorts a basket of long-term Treasuries, should be a no brainer as the Fed tightens monetary policy.

Nevertheless, over the last month TBF has fallen 3.85% and continues to be mired in a pervasive downtrend. This ETF is below its long-term moving average and looks ready to test its 52-week lows in the near future as well.

What many underestimated in this trade is the volatility in stocks driving a traditional “flight to quality” in long-term Treasuries. In addition, the actual mechanics of an interest rate hike are all centered around the short end of the yield curve. This has little effect on the price of long duration bonds, which are driven by conventional market forces of buyers and sellers.

PowerShares Exchange-Traded Fund Trust II BKLN

Remember when senior loans and floating rate notes were going to be the cure to your rising rate woes? That thesis was predicated on the notion that these debt instruments were insulated from interest rate risk because of their adjustable duration component. This makes their effective duration very short as it floats in relation to a benchmark such as LIBOR.

However, the little-talked about risk in these securities is a contracting credit environment. A fund such as BKLN is sensitive to credit headwinds similarly to the iShares High Yield Corporate Bond ETF (HYG).

This ETF peaked near the middle of 2015 and has been in a steady decline lower ever since. On a net basis, BKLN is virtually flat since the Fed rate hike and continues to show a high correlation to credit sensitive junk bonds.

Despite the short-term woes, BKLN may ultimately regain its footing if the stock market can turn the corner or regain some form of stability. In addition, it offers a current 30-day SEC yield of 7.03%, which will be attractive for aggressive income investors looking to capitalize on distressed prices.

ProShares Investment Grade Interest Rate Hedged IGHG

IGHG is a unique corporate bond fund designed to hold long positions in a basket of investment grade stocks alongside short positions in U.S. Treasury bonds. The goal is to “hedge” the interest rate risk that is typically associated with a group of high quality bonds at a reasonable expense ratio of 0.30%.

IGHG has fallen prey to relatively weak demand in investment grade corporate bonds combined with falling interest rates on the longer end of the yield curve. This ETF has dropped 2.09% over the last month and continues to demonstrate a lack of market fear in the rising rate thesis.

The IGHG strategy is designed to collect the income from the underlying bonds without suffering significant capital depreciation as intermediate-term Treasury yields rise. This isn’t a reality in the current fixed-income environment, but may become a more sought after tool when rates eventually reverse course.

The Bottom Line

Many of the funds on this list are sound vehicles that are designed to perform with specific fundamental characteristics or in a contrarian environment. Their lack of participation in the short time since the Fed rate hike doesn’t mean that they won’t offer measurable value at some point in the future. Investors considering these tools to enhance their portfolio should be mindful of what factors may contribute to a turn in the current trend or continue to drag them lower.

Furthermore, these examples highlight the difference between theory and practice when considering how investments will react in the aftermath of a specific market event. Just because something “should” work doesn’t mean that it is guaranteed to do so. Make sure to wait for price to confirm your thesis before committing to a new direction with your bond allocations.

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This was originally shared on FMD Capital Management