Recently, a new breed of high-yield exchange-traded funds have been released that seek to mitigate the risk of rising interest rates by combining long positions in high-yield debt with short positions in U.S. Treasuries. Both the Market Vectors Treasury Hedged High Yield Bond ETF (NYSEARCA:THHY) and the First Trust High Yield Long/Short ETF (NASDAQ:HYLS) follow this strategy in an attempt to outperform traditional high-yield funds in an inflationary environment.
The premise behind this strategy is that with interest rates at historic lows, the funds will benefit from a rising interest rate environment by shorting five-year Treasury bonds. In theory, the short Treasury bond component to the portfolio will offset a portion of the interest rate risk of the high-yield debt. The fund managers believe that this will lead to better risk-adjusted returns over time.
While this theory makes sense in a rising interest rate world, these funds will both significantly underperform their peers if we see a flight to quality in Treasury bonds and a concomitant decline in high-yield bond prices. In addition, when you dig deeper, it becomes apparent that this strategy is very expensive to achieve based on the expense ratios of the funds. HYLS charges 1.19%, which includes leverage costs, and THHY has a net expense ratio of 1.45%.
While I don't mind paying for performance or a unique strategy, these fees seem very expensive at face value. When you compare that with the expense ratios for some of the biggest and most widely held junk bond funds, you can see that they are two or three times more expensive.
- iShares High Yield Bond ETF (NYSEARCA:HYG) -- 0.50% expense ratio
- SPDR Barclays High Yield Bond ETF (NYSEARCA:JNK) -- 0.40% expense ratio
- PIMCO 0-5 Yr High Yield Bond ETF (NYSEARCA:HYS) -- 0.55% expense ratio
Based on the current trend of high yield (as seen in the chart below) and the Federal Reserve's commitment to keeping interest rates at exceptionally low levels for the next several years, I would not be running to hedge your bond portfolio just yet. It is my belief that we could see a sideways trend in interest rates for some time, which would allow you to continue to collect monthly income with the potential for further capital appreciation.
One strategy that may make sense when it comes time to hedge your bond portfolio down the road is to purchase a small position in the ProShares Short 7-10 Year Treasury (NYSEARCA:TBX). This would allow you to continue to collect the monthly dividends from your fixed-income positions while offsetting the interest rate risk of long-term inflation. In addition, you have the flexibility and liquidity to move the hedge in and out of your bond portfolio as market conditions change over time.
Disclaimer: Fabian Capital Management, and/or its clients may hold positions in the ETFs and mutual funds mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities.