What if they gave a party for highest interest rates and no one came?

That in effect is the question facing retirees who have invested in, or are considering investing in—bond funds that are hedged against higher interest rates. I wrote about these funds before, at a time when the nearly-universal consensus on Wall Street was that rates would rise markedly. It seemed to make perfect sense to hedge against the losses to which those higher rates would inevitably lead.

But, as so often happens on Wall Street, the markets did precisely the opposite of what everyone was expecting. In contrast to a 10-year Treasury yield

TNX, +0.71%

above 3% when I last wrote about these funds in November, it is barely half that level today.

Not to bury my lead too much: These funds have acquitted themselves quite well this year. Though their hedges cut into their profits, they still produced modest gains—and in the process illustrated to all of us their long-term potential.

Assuming the future is like the past, these interest-rate hedged bond funds present retirees with an attractive trade-off: Your profit should be close to these funds’ current yield, regardless of whether rates rise, fall or stay more or less where the stand now.

Two of the largest rate-hedged bond funds are the iShares Interest Rate Hedged Corporate Bond ETF

LQDH, -0.03%

and the iShares Interest Rate Hedged High Yield Bond ETF

HYGH, -0.10%.

The unhedged versions of these two funds are the iShares iBoxx $ Investment Grade Corporate Bond ETF

LQD, +0.08%

and the iShares iBoxx $ High Yield Corporate Bond

HYG, +0.02%.

For the year to date (through Sep. 26), both rate-hedged funds performed less well than their unhedged versions. Nevertheless, each still produced a respectable return: 4.6% for LQDH (versus 15.3% for the unhedged LQD) and 7.8% for HYGH (versus 11.3% for HYG).

Indeed, 9-month returns of 4.6% and 7.8% would be entirely satisfactory for a bond fund in any other year besides this one. It’s only in contrast to the double-digit returns that the unhedged versions of these bond funds produced that anyone would even think of being disappointed.

To understand these rate-hedged funds’ potential going forward, it’s helpful to recall what Finance 101 taught us about the two sources of bonds’ risk—and the return they should earn to compensate investors for those risks: The risk of higher rates (so-called “Duration” risk) and the risk of default (“Credit” risk). To the extent a bond fund’s rate hedges are successful, then—in theory—the only remaining risk the fund faces is credit risk. And such a fund’s expected return going forward will be compensation for incurring that credit risk.

Needless to say, high-yield bond funds (aka junk) face much higher credit risk, which is why they generally have a much higher yield. So long as the economy remains strong enough to prevent widespread defaults, investors in the hedged high yield fund should be able to realize that yield. This is why the rate-hedged high yield fund has earned nearly double the return this year than of the rate-hedged investment grade fund.

Note carefully that these funds’ hedges are to insure against higher rates, however. They do not provide any insurance against defaults—credit risk. So if and when the economy suffers a recession, the rate-hedged investment grade funds are likely to do better.

Finance 101 also helps us to understand why you never see a rate-hedged Treasury bond fund. That’s because, at least in theory, there is no credit risk associated with owning U.S. Treasurys. So if you hedge away their duration risk, such a fund would be nothing more than an expensive money-market fund.

The bottom line? If and when interest rates rise, then unhedged bond funds will suffer. If you are unwilling to tolerate that risk and uncertainty in your retirement portfolio, then a rate-hedged fund bond is definitely worth considering.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. Hulbert can be reached at mark@hulbertratings.com.

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