Should You Invest in Hedged High-Yield Bond ETFs?

One good aspect of the growing number of bond exchange-traded funds (ETFs) is that there are now portfolios covering needs that investors never even knew they had. The downside is that some of the strategies in these ETFs can be very hard to figure out. One type of these complex ETFs that came on the scene in 2013 is the hedged high-yield bond ETFs.

Hedged High-Yield Bond ETFs: The Basics

These ETFs seek to provide people who invest with the good yields of high-yield bonds but without the element of interest rate risk that can come along with bond investing. The funds do this by complementing their high-yield portfolios with a short position in U.S. Treasuries. A short position is an investment that rises in value when the price of a security declines. Since bond prices fall when yields rise, a short position in bonds would gain in value when yields are rising.

For instance, the FirstTrust High Yield ETF (HYLS) borrows money to invest in high-yield bonds that it expects to outperform. It creates a short position in U.S. Treasuries and/or corporate bonds. This short position acts as the “hedge” to the rest of the portfolio.

This approach allows the funds to confine the two types of risk in high-yield bonds: credit risk and interest-rate risk. Credit risk is the risk of defaults and changes in conditions that could affect the default rate, such as economic growth or corporate earnings. Interest-rate risk is that change in Treasury yields will affect performance. These funds get rid of most of the latter risk, which provides “pure” exposure to credit risk.

This is all well and good when people have a good outlook about credit risk, for instance when the economy is strong and firms are doing well. On the other hand, the hedged approach is a negative when credit conditions start to go downhill. In this case, credit risk becomes a liability, while interest-rate risk acts as a positive attribute since it cushions some of the downsides.

What are the Options in Hedged High-Yield Bond ETFs?

As of early 2022, you have four options from which to choose:

• WisdomTree BofA Merrill Lynch High Yield Bond Zero Duration Fund (HYZD) Expense ratio: 0.43%
• First Trust High Yield Long/Short ETF (HYLS), 0.95%
• ProShares High Yield-Interest Rate Hedged ETF (HYHG), 0.51%
• iShares Interest Rate Hedged High Yield Bond ETF (HYGH), 0.52%

Pros and Cons of Hedged High-Yield Bond ETFs

The main advantage of hedged high-yield bonds funds is that they can reduce the impact of rising bond yields. This can allow you to earn good yields without having to worry about the likelihood that Treasury yields will rise. At the very least, this should dampen risk compared to a traditional high-yield bond fund. In a best-case scenario, it may lead to a modest performance advantage.

Still, these funds also have a number of cons that you should be well aware of.

Low-interest-rate risk doesn’t mean “low risk”: Investors can’t assume that these funds are free from risk since credit risk remains a vital part of their performance. An adverse event in the global economy could cause high-yield bonds prices to fall at the same time as Treasury prices gain amid a “flight to quality.” In this scenario, both portions of the fund would have a downside, since the funds are hedged only against rising bond yields.

High-yield bonds have limited interest-rate risk to start with: While high-yield bonds have interest-rate risk, they are less interest-rate sensitive than most segments of the bond market. As a result, investors are hedging a risk that is already lower than that of the typical investment-grade bond fund.

Results will differ from the broader high-yield market over time: People who are looking for a pure high-yield play won’t find it here. The funds may give returns that are fairly close to the high-yield bond market on a daily basis, but over time these small differences will add up. In turn, this leads to returns that are far from what you may expect.

They haven’t been proven in a tough climate: It’s always wise to give newer funds some time to prove themselves. That’s even more true in this case given that the funds haven’t had a long time with the adverse combination of losses in the long high-yield and short-Treasury portfolios. Until there’s a body of proof of how that scene would play out, you should give these funds a pass.

Expenses are high for HYLS: This fund carries a hefty expense ratio of 0.95%. In contrast, the two most popular non-hedged ETFs, iShares iBoxx $ High Yield Corporate Bond ETF (HYG) and SPDR Barclays High Yield Bond ETF (JNK) have expense ratios of 0.48% and 0.40%, respectively. Over time, these added expenses can take a big bite out of any return advantage HYLS might have.

The approach assumes that Treasury yields will rise: Treasury yields are likely to rise over time, but there is no guarantee. Keep in mind that these funds lose a key selling point if yields stay flat for many years.

The Bottom Line

Hedged high-yield bond ETFs are an interesting approach, and they may indeed prove their value if Treasury yields embark on the long uptrend that some investors see in the coming decade. At the same time, there are a number of cons that point to these funds being a solution in search of a problem. Take care not to put too much value into the hedged approach.

Disclaimer: The information on this site is provided for discussion purposes only, and should not be construed as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities. Always consult an investment advisor and tax professional before you invest.