iShares launches euro corporate bond ETF that hedges interest rate risk

Oct 23rd, 2012 | By | Category: Fixed Income

iShares, the exchange-traded funds (ETF) platform of BlackRock, has announced the launch of the iShares Barclays Capital Euro Corporate Bond Interest Rate Hedged ETF (IRCP), the first ETF to offer physical corporate bond exposure with mitigated interest rate risk.

iShares launches euro corporate bond ETF that hedges interest rate risk

The iShares Barclays Capital Euro Corporate Bond Interest Rate Hedged ETF (IRCP) mitigates the impact of rising Eurozone interest rates on corporate bonds by shorting German government bond futures.

With government bond yields at historic lows and investors increasingly seeking out extra income by investing in corporate bonds, this product will likely appeal to those investors who want to obtain that extra yield but are concerned about what may happen to corporate bond prices if interest rates start to rise.

While the performance of European corporate bonds has been strong, illustrated by the Barclays Euro Corporate Bond Index increasing 19.2% in the past three years, this can broadly be attributed to the performance of German government bonds, which make up approximately 14% of the return, which represents the interest rate risk component of this index.

The yield of German government bonds has continued to fall throughout the European economic crisis due to their nature as a safe-haven investment. It is now at an historic low. A potential future rise in German government bond yields could push up the corporate bond yield curve and ultimately lower corporate bond prices.

This new ETF protects against such a potential upward shift by hedging out the inherent interest rate risk using German government bond futures. The hedging methodology consists of selling German government bond futures contracts in order to target a portfolio duration of zero. The short position in German government bond futures contracts would profit from falling bond prices, a consequence of rising interest rates.

Commenting on the launch, Alex Claringbull, senior fixed income portfolio manager for BlackRock’s iShares fixed income range, said: “This new fund buys physical corporate bonds, and sells German government bond futures against those purchases, offering isolated credit exposure that allows investors to earn the extra corporate bond yield they are seeking. It can also be a great way to protect your portfolio from any future rise in government bond yields.”

The Barclays Capital Euro Corporate Bond Index contains fixed-rate, investment-grade Euro-denominated bonds from industrial, utility and financial issuers only. Inclusion is based on the currency of the issue, and not the domicile of the issuer. Currently, French issuers comprise 19.6% of the index, German issuers make up 12.6%, Dutch issuers represent 12.0%, while US and UK issuers contribute 11.7% and 11.3% respectively. In terms of industry allocation, banking dominates with 39.9%, followed by communication with 10.4%, consumer (non-cyclical) with 9.4%, consumer (cyclical) with 6.5% and electric with 5.1%.

The fund is listed on the London Stock Exchange and comes with an annual total expense ratio (TER) of 0.25%. It is physically backed and tracks the index using a sample-based replication methodology.

For sophisticated investors, a potential alternative to the new iShares fund could be one of the credit-based ETFs from Deutsche Bank’s db X-trackers unit. Among the funds worth looking at is the db X-trackers iTraxx Europe 5-Year TR Index ETF (XTXE) and the db X-trackers iTraxx Crossover 5-Year TR Index ETF (XTXC), both of which are listed on the Deutsche Börse, Borsa Italiana and the SIX Swiss exchanges and come with TERs of 0.18% and 0.24% respectively.

These products allow investors to take on pure credit risk exposure – as opposed to the credit plus interest rate risk generated through investing in corporate bond indices – to the European corporate credit market by tracking the performance of iTraxx credit default swap (CDS) indices. CDS indices measure the return generated from selling credit protection.

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