Using ETFs To Measure Interest Rate Risk

When managing a fixed income portfolio, there are two primary risk factors that financial advisors consider: credit risk and interest rate risk. The superstar bond fund managers of the world have set themselves apart by a superior ability to identify these risk components–and then select securities that offer superior risk-adjusted returns. The first risk factor is easy enough to understand; the more likely an issuer of debt is to default and leave bondholders with nothing, the greater the return that will be demanded by those lending money. Companies and countries with stellar credit ratings and strong cash flow profiles can borrow funds at relatively low rates of interest, while more speculative issuers will have to pay significantly more in interest to compensate for the additional credit risk. Disparities in credit risk explain why Wells Fargo can issue debt with a 3.75% coupon, while less stable companies such as First Data are issuing debt with coupons of about 12.6%. Many fixed income managers devote significant portions of time attempting to identify disparities between the interest companies are paying on debt and their actual credit risk; figuring out a disconnect can result in an opportunity to generate alpha.