Since early 2016, the trend in credit-sensitive securities has been predominantly higher as yield spreads compress and risk behavior leans on the bullish side. Income-focused investors have poured billions of dollars into exchange-traded funds that track these markets, led by the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) and SPDR High Yield Corporate Bond ETF (JNK). Both funds have been cherished for their above-average income streams and historically low volatility in relation to the basket of riskier debt that underpins their portfolios.
More recently, HYG and JNK have exhibited several sharp down days despite the relative calm buoying the global equity markets. This divergence has many bond investors worried about the future growth prospects of high yield debt and whether they should shield their gains from a potential correction in risk assets.
For some, the obvious choice will be to sell and move to cash in the expectation of watching a correction unfold from the sidelines. That strategy may be prohibitive for those who rely on a certain degree of income or who desire a fully invested portfolio strategy. Furthermore, the risk of selling out of the market completely is that these bonds quickly shoot higher after a short bout of volatility and you miss out on further upside.
ETF providers have tailored several defensive options for the high yield markets depending on your risk tolerance and market outlook. One popular strategy is to shorten the overall duration of your holdings to reduce their sensitivity to interest rates. The iShares 0-5 Year High Yield Corporate Bond ETF (SHYG) and PIMCO 0-5 Year High Yield Corporate Bond ETF (HYS) are two examples of this group.
Both funds carry an effective duration of approximately 2 years versus the 3.7-year duration of HYG. They currently offer 30-day SEC yields in the 4.6-4.8% range, which is still attractive given their penchant for less volatility than traditional intermediate-term indexes.
Another plausible option for those concerned about the impact of rising rates is the iShares Interest Rate Hedged High Yield Bond ETF (HYGH) or ProShares High Yield Interest Rate Hedged ETF (HYHG). It’s easy to get those ticker symbols mixed up, so be careful with your typing. Both funds take a unique approach by owning a broad universe of high yield debt paired with short positions in Treasury futures.
The goal is to net out the effective duration of the fund to nearly zero, while still retaining the monthly income stream that investors desire. Of course, these types of funds would still be susceptible to a pronounced shock in the credit markets and would likely underperform if interest rates were to move sharply lower.
Lastly, there is a relatively new alternative to consider in the defensive arena. BlackRock recently launched the iShares Edge High Yield Defensive Bond ETF (HYDB) as a smart beta style index fund with intriguing potential. This ETF seeks to mitigate risk by employing fundamental screening criteria for quality and value characteristics.
Put simply, HYDB seeks to avoid overpriced and higher risk securities by screening out those companies more susceptible to default. It also weights the selected holdings towards bonds with attractive default-adjusted spreads rather than simple market capitalization weightings. This strategy may not necessarily act as a direct hedge like its peers, but may have the potential to moderate price swings over long time frames.
The Bottom Line
One of the most important axioms for income investors to embrace is that high yield equals high risk. Every incremental step up in dividends is going to come with an associated higher risk of principal. This philosophy should be the framework behind the varying dynamics of defensive ETFs and evaluating how cyclical market forces will impact their returns.