AGRH ETF: new covered bond offering from iShares

Andrii Yalanskyi

Thesis

The iShares Interest Rate Hedged US Aggregate Bond ETF (AGRH) is a brand new offering from iShares. The fund was launched in mid-June and has only two weeks of trading activity. According to the fund literature:

1. Holds iShares Core US Aggregate Bond ETF shares (AGG) and interest rate swap positions

2. Aims to track an index that seeks to mitigate interest rate risk

3. Use to manage interest rate risk or express an opinion on credit spreads

The ETF seeks to track the investment results of the BlackRock Interest Rate Hedged US Aggregate Bond Index, which seeks to minimize exposure to interest rate risk from a portfolio of investment grade bonds denominated in U.S. dollars. Basically, the index tracks the iShares Core US Aggregate Bond ETF with a predetermined hedging profile consisting of a maximum of 10 swaps:

AGG Index Eligibility Criteria

Indexing criteria (BlackRock)

Swaps are designed to minimize interest rate risk for each duration bucket for the respective ETF:

Each index in the series is constructed by combining its single associated ETF with 10 interest rate or inflation swaps with maturities of 1, 2, 3, 5, 7, 10, 15, 20, 25 and 30 years. The weighting of each swap contract is calculated to best achieve neutral durations of the key rate (KRD) of the index at the points of 1, 2, 3, 5, 7, 10, 15, 20, 25 and 30 years. Each index ETF will be held with a fixed number of shares (to be adjusted in the event of a stock split), while the swap weights will be rebalanced daily. Rebalancing takes place at the end of each business day, with new weightings taking effect the following business day

Source: Index Methodology

Ultimately, an investor should view AGRH as an interest rate hedged exposure to the underlying AGG ETF. By buying AGRH, you lock in credit spreads and should be interest rate risk neutral. The fact that iShares is offering such a product after a vicious fixed income rout in 2022 (AGG is down more than -10% year-to-date) should send a bit of a contrary signal to rate traders. . Usually products like these appear on cycle tops. The AGRH is nonetheless a good choice to pursue if an investor only looks at credit spreads or wants a hedged product for the next cycle of monetary tightening. AGG has a duration of 6.7 years, so most of the price movement this year was due to rates. There are no analytical metrics for AGRH yet since it just started trading, so we cannot present any risk/reward metrics for the fund.

The ETF has a fairly low expense ratio of 0.13% and a near-zero duration (the fund’s reported duration is 0.06 years). We see AGRH as a packaged institutional product that is now also available to retail investors. An institutional investor already has the ability to perform interest rate swaps and therefore hedge a position in AGG, but not a retail investor. Additionally, the fact that the fund manager is responsible for adjusting swap notionals and keeping the duration profile for AGRH close to zero also removes an operational and commercial burden for an institutional investor.

Assets

The current sector composition is as follows:

AGRH participations

Holdings (iShares)

The main concentrations are in treasury bills and fixed rate agency securities which represent more than 60% of the fund.

The breakdown of asset ratings follows the aggregate composition of the index:

AGRH Rankings

Asset Valuations (iShares)

The fund is mainly composed of AAA securities where credit spreads are minimal. By hedging interest rate risk, the fund essentially provides the investor with exposure to credit spreads and the cost of the balance sheet (i.e. the additional yield that a security must offer to be held in balance sheet).

AGG ETF Performance

Since AGRH is an interest rate hedged version of AGG, let’s look at the performance of the underlying ETF:

Performance of AGG ETFs

Year-to-date total return (seeking alpha)

AGG is down more than -10% based on prices in 2022. Most of the movement is due to the duration of the fund which stands at 6.7 years and the violent reset higher in rates.

On a 5-year basis, AGG shows an annualized total return of less than 1%:

AGG 5-Year Total Return

5-year total return (seeking alpha)

We can see how AGG’s performance is mainly driven by rates – while the Fed cut rates in 2020, the ETF saw most of its gains. Given its composition, which is AAA for more than 68% of the collateral, the fund’s total return comes mainly from the rate component.

We would expect HRMA to have a much more normalized total return profile that shows a slightly increasing characteristic each year.

Conclusion

The iShares Interest Rate Hedged US Aggregate Bond ETF is a brand new offering from iShares. The ETF provides the investor with hedged interest rate exposure to AGG. The ETF ultimately has the same underlying collateral composition as AGG with up to ten interest rate swaps overlaid to hedge duration risk. AGRH has a net duration of 0.06 years, but just started trading two weeks ago, so no meaningful total return data is available. After a sharp rout in fixed income since the beginning of the year due to rising rates, we believe that the launch of a new product like AGRH, which aims to hedge interest rate risk, could mark a peak in rates.

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