Using ETFs to Hedge Against Widening "Credit Spreads"

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Includes: HYG, IEF, LQD
by: Gary Gordon

Friday morning, a reporter for a major U.S. financial publication asked me to comment on widening credit spreads; specifically, what might a worried investor do about the increasing gap between high-yield corporate bonds and the 10-year U.S. treasury bond?

Stop worrying! (No, I didn't say that.)

By historical standards, though, the 3% "spread" between high-yield (a.k.a. "junk") and the 10-year (a.k.a. reasonably safe debt) is still relatively low. And that suggests that stock market investors should not get bent out of shape just yet.

Nevertheless, both equity investors and bond investors should be wary if credit spreads widen significantly. It often suggests that investors could be losing their appetite for risk; after all, they appear to be selling riskier high-yield assets more than they are selling safer 10-year bonds.

Could it also mean that companies will have difficulty buying other companies with debt financing? Sure. If corporations have higher borrowing costs, they may not be able to raise as much cash to make mega-deals. And it's the mega-deals that has fueled much of the stock surge in 2007.

Bottom line, however. I am not going to rain on the stock market parade. Pundits have been making that mistake every step of the way... from Dow 10,000 to Dow 11,000 to Dow 12000 to Dow 13000 to Dow... is it close to 14000?

I will, however, offer a bond market solution for credit spread watchers; that is, if you believe that widening spreads will continue, one can use ETFs to effectively hedge against risk.

How? One might own the iShares Lehman 7-10 Year Treasury Bond Fund (NYSEARCA:IEF) and short the iShares Goldman Sachs Corporate Bond Fund (NYSEARCA:LQD) or short the new iShares iBoxx High Yield Corporate Bond Fund (NYSEARCA:HYG).

Hedgers should be aware, however, that spreads between high-risk debt and low-risk debt may not continue to widen. They may even tighten again. In fact, spreads often narrow in rising rate environments.

I guess the bigger question is, are we in a rising rate environment anymore?

Disclosure Statement: As a Registered Investment Advisor, Pacific Park Financial, Inc. may hold positions in the ETFs, mutual funds and/or index funds mentioned above.

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