So far, 2018 has not been an easy year for high-yield bond ETFs. The two largest funds in the segment—the $15 billion iShares iBoxx $ High Yield Corporate Bond ETF (HYG) and the $9 billion SPDR Bloomberg Barclays High Yield Bond ETF (JNK)—have faced sizable asset outflows as investors fret over high valuations and rising interest rates.
But there’s an ETF in this segment that seems to be thriving in these troubled waters, bucking the redemptions trend by gaining modest assets instead. It’s the iShares Interest Rate Hedged High Yield Bond ETF (HYGH).
Source: FactSet data
HYGH isn’t the only rate-hedged ETF on the market, but it offers here a great example of how these types of strategies are constructed and how they perform in the rising rate environment we are seeing.
Consider that from a performance perspective, HYGH has outperformed its massive, well-established nonhedged competitors this year, registering the lone gain for the year of the three.
Behind HYGH’s relative resilience is its unique interest-rate-hedged portfolio. So far in 2018, 10-year Treasury yields have risen about 0.45% to 2.87%. Going back 12 months, yields were around 2.45%. When interest rates rise—yields rise—the value of Treasuries declines. If you were to short Treasuries, you would profit from that value decline.
HYGH essentially shorts Treasuries by holding a portfolio of interest rate swaps against an allocation to HYG. The swaps bring down the duration of the overall portfolio to near zero, compared with HYG’s 3.86-year duration, all the while keeping a similar yield profile.
The longer the duration, the more sensitive a bond portfolio is to interest rate changes, so HYGH’s much shorter duration is its protection against higher rates. (The yield difference between HYGH and HYG depends on the absolute level of interest rates as well as the rate of change in interest rate movements, according to BlackRock.)
HYGH currently holds about $298 million in notional amounts of interest rate swaps against a $255 million position in HYG, a near 50-50 split, BlackRock says.
Pure Credit Risk
“The two big risk components for high-yield bonds are interest rate risk and credit risk,” said Scott Burley, ETF analyst at FactSet. “These two tend to be countercyclical—rising rates lead to lower bond prices, but they also imply a strong economy, which implies narrowing credit spreads and rising prices for high-yield bonds. By hedging out interest rate exposure, HYGH is more of a pure-credit-risk play.”
By design, HYGH can benefit from its interest rate hedges when rates rise. But on the flip side, the fund could also be more exposed to the impact of widening credit spreads than traditional HYG would. That’s because interest rate exposure can offer a buffer for credit risk, according to Burley.
“Hedging out interest rates makes HYGH more volatile, with an annualized standard deviation of 7.96% over the past three years versus 6.50% for HYG,” Burley noted. “That’s not quite as volatile as equity, but it’s close.”
What’s more, high-yield bonds already have less interest rate exposure to begin with relative to an aggregate-type investment-grade portfolio, such as the iShares Core U.S. Aggregate Bond ETF (AGG), because junk bonds often have large coupons and short maturities. That combination tends to lower average effective duration. Consider that HYG has a duration of about 3.6 years, while AGG is at 5.8 years.
High Equity Correlation
“The attraction of HYGH is that it offers high income without interest rate risk—obviously desirable when higher rates are expected,” Burley explained.
“HYGH makes sense as a replacement for an unhedged junk bond position for someone who strongly expects rates to rise and wants to protect against that, with the understanding that they’re taking on extra credit risk in exchange,” he added.
The performance will likely be highly correlated to equities, more volatile than an allocation to HYG alone, and one that can potentially benefit from rising interest rates.
Rate-Hedged ETFs To Choose From
In the high-yield bond ETF segment, there are at least four ETFs that set out to offer access to dollar-denominated junk bonds in a portfolio with net-zero or close-to-zero duration achieved through shorting Treasuries.
HYGH, which came to market in May 2014, is the biggest of them, with $259 million in total assets and an expense ratio of 0.54%.
HYGH goes head to head against the Xtrackers High Yield Corporate Bond Interest Rate Hedged ETF (HYIH), a fund that owns high-yield bonds and shorts Treasuries, and has $3.5 million in total assets for a 0.35% fee. HYIH is the cheapest of them, but the fund has seen net redemptions of about $6 million so far in 2018.
There’s also the ProShares High Yield-Interest Rate Hedged ETF (HYHG), which owns high-yield U.S. and Canada-issued bonds, while shorting a duration-matched combination of two-, five- and 10-year U.S. Treasuries. HYHG, which come to market in 2013, has $177 million in total assets for 0.50% in fees. Year-to-date, HYHG has attracted $37 million in net inflows.
The WisdomTree Interest Rate Hedged High Yield Bond Fund (HYZD) tracks a long/short net-zero duration bond index. It owns U.S. high-yield bonds and shorts Treasury futures, in a portfolio that has $147 million in total assets and a 0.43% price tag.
Here’s a look at how these funds have performed in the past 12 months:
Charts courtesy of StockCharts.com
Contact Cinthia Murphy at [email protected]