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New ETFs Combat Rising Rates, Inflation & QE

February 22, 2013
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ETF issuers are getting increasingly creative in addressing an entirely new economic landscape.

 

Thanks to unprecedented action from all major central banks around the world, investors—much like Dorothy in “The Wizard of Oz”—find themselves in a strange and unfamiliar landscape. This time however, investors are concerned about rising rates, inflation and quantitative easing, not lions, tigers and bears.

ETF issuers, whose ultimate goal is to deliver products that attract investor assets and add to their bottom line, have been addressing this issue at an increasing pace in recent months. Four recent and approaching ETF launches, in particular, highlight how issuers are addressing investor concerns.

Those four products are the Market Vectors High-Yield/Treasury Bond ETF; the Pimco Foreign Currency Strategy ETF; the Pimco Government Limited Maturity ETF; and the Pimco Prime Limited Maturity ETF. I’m addressing these four products explicitly because they’re new (or will be) to the market and, given the current environment, may prove particularly useful to investors.

The first fund, the Market Vectors High-Yield/Treasury Bond ETF (THHY), is an especially interesting option that allows investors to maintain fixed-income exposure while limiting interest rate risk. The fund hasn’t hit the market yet, but it should be soon, so check back for launch coverage.

THHY takes a long position in the components of a high-yield corporate bond index and a short position in five-year U.S. Treasury notes. As interest rates increase, the gains from the short position ought to offset the losses from the long position.

What’s left? Credit exposure. This fund ought to gain on narrowing spreads between the yield on high-yield corporate bonds and five-year Treasury notes. So the question is, Where are spreads now? How much can they narrow?

According to the BofA Merrill Lynch US High Yield Master II Option-Adjusted Spread time series, the yield spread between high-yield debt and U.S. Treasury notes is currently just shy of 5 percent, indicating that, on average, high-yield corporate bonds are yielding 5 percent more than “risk-free” U.S. Treasury notes. Phrased differently, investors demand a 5 percent premium to bear the credit risk of high-yield lenders.

Time Series/Credit Spread

To put it in perspective, since 1997, a little over 40 percent of all observations have had tighter spreads than the current 4.95 percent; the tightest spread was 2.41 percent back in June 2007.

Distribution Frequency/Credit Spread

In order to increase in value, THHY needs spreads to narrow. Considering that roughly 40 percent of all historical observations have spreads below today’s value, strictly from a historical perspective, the prospect seems at least plausible.

However, the distribution table also highlights the asymmetric nature of risk in this particular case. Spreads could fall 2.5 percent to near their all-time low of 2.41 percent, or they could rise to their historical highs, which are north of 20 percent.

 

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