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Warning Flags For High Yield Investors

In a post at the CFA Institute website on Wednesday, fixed income manager David Schawel raised two warnings for high yield investors:

- Valuation Risk. Schawel quoted Loomis Sayles Bond Fund manager Dan Fuss on the state of high yield:

High yield is as overbought as I have ever seen it. This is absolutely, from a valuation point, ridiculous.

Incidentally, Fuss made a similar point about the bond market in general to Bloomberg recently, saying that bonds were more overbought than any time in the last 55 years.

Schawel also quoted another Loomis Sayles fixed income manager, Matt Eagan, who pointed out that high yield bonds generally don't trade for more than par plus half their coupon (due to call risk), and that they were trading above that now.

- Price Risk. Schawel noted that average high yield bond coupons had fallen since three years ago -- both in absolute terms, and in a narrowing of the spreads between high yield and investment grade coupons -- and explained that this effectively increased the duration of high yield bonds. And higher duration means more price risk, as bond prices become more sensitive to increases in interest rates.

Hedging High Yield ETFs

Investors who own the iShares iBoxx $ High Yield Bond ETF (NYSEARCA:HYG), or the SPDR Barclays High Yield Bond ETF (NYSEARCA:JNK), and are concerned about downside risk in light of the warnings above, can hedge with optimal puts*. Below, we'll show the optimal puts to hedge both high yield ETFs against greater-than-15% declines over the next several months. We're using 15% decline thresholds here because they seem to offer reasonable balance of cost and protection, but investors with lower risk tolerances may want to consider hedging with smaller decline thresholds, or simply reducing their exposure to high yield.

Hedging HYG

The screen capture below shows the optimal puts, as of Wednesday's close, to hedge 1,000 shares of HYG against a greater-than-15% drop by September 20th.

As you can see at the bottom of the screen capture above, the cost of this downside protection, as a percentage of position, was 1.34%. Note that, to be conservative, cost here was calculated using the ask price of the optimal puts; in practice an investor can often buy puts for a lower price (i.e., some price between the bid and the ask).

Hedging JNK

The screen capture below shows the optimal puts to hedge JNK against a greater-than-15% decline over the same time frame.

As you can see at the bottom of the screen capture above, the cost of this downside protection, as a percentage of position, was 0.99%.

No Optimal Collars For JNK Or HYG

In recent posts (such as this one about hedging Priceline.com (NASDAQ:PCLN)), we've showed how investors who are willing to cap their upside potential can, in some cases, reduce or eliminate their hedging costs by using optimal collars. That's not the case with these two ETFs.

Recall that collars are comprised of a long put leg, which provides downside protection for the underlying security, and a short call leg, which offsets the cost of the put protection while capping the investor's potential upside. Optimal collars are the ones that provide the level of protection an investor specifies at the lowest net cost, while not limiting the investor's upside by more than the investor specifies. There were no optimal collars available for HYG on Wednesday, and none available for any cap over 1% for JNK, because most of the September expiration out-of-the money calls on these two ETFs have no bids. That may be a third warning flag for high yield investors.

*Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. Portfolio Armor uses an algorithm developed by a finance PhD to sort through and analyze all of the available puts for your stocks and ETFs, scanning for the optimal ones

Source: Warning Flags - And Ways To Hedge - For High Yield ETF Investors