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New Junk Bond ETF Hedges Risks In Interest Rates

By: Investor's Business Daily
Posted: 3/22/2013 12:25:00 PM
Referenced Stocks: HYG;IEI;JNK;THHY;VGIT

Van Eck launched a new ETF on the stock market today  that pays monthly interest payments from junk bonds while hedging its bets should interest rise back to normal levels.

Market Vectors Treasury-Hedged High Yield Bond ETF ( THHY ) holds a portfolio of high-yield corporate bonds while shorting five-year Treasury notes. Bond prices and yields move in opposite directions. And the greater a bond's duration, the most sensitive it is to interest rate changes.

If interest rates rise, the high-yield bond prices will fall while the short position in Treasuries will rise, dampening the price drop in the junk bonds.

But watch out for an environment of falling rates. "Falling interest rates and negative high-yield performance, as in 2008, will result in significant loss of return," Van Eck states in the prospectus and fund fact sheet.

Rising interest rates and narrowing credit spreads, as in 2009, will produce gains when subtracting the performance of the five-year Treasuries from the bond portfolio. Flat interest rates and narrowing credit spreads, as in 2012, will result in gains.

THHY plans to pay dividends monthly. It charges a hefty management fee: 1.45% of assets a year.

"I would only recommend THHY for those who could afford some risk in their portfolio and probably not more than a 3%-5% allocation," Ronald Lang, principal at Atlas Wealth Management in Philadelphia with $20 million in assets under management, said in an email. "It may not be worth the added expense if you are looking longer-term -- more than five years -- because interest rates can only go in one direction, up, which will bring down the bond prices.

"As long as the interest rates stay under 1.5%-2%, then stay short-term (two-four years) with THHY," Lang added. "If there is a sell-off in high-yield bonds, this is only a small part of your portfolio and they are paying you a monthly dividend."

Bonds in the portfolio yield an average of 4.33% and have an average duration of nearly nine years.

"With inflation, taxes and advisory fees built in, the client will need an annual gross return of 6% or better to make this ETF a worthwhile part of their defensive portfolio allocation," Lang wrote.

Successful investors could reproduce the strategy by buyingSPDR Barclays High Yield Bond ( JNK ) or iShares iBoxx $High Yield Corporate Bond ( HYG ) and shorting iShares 3-7Year Treasury Bond ETF ( IEI ) orVanguard Intermediate-Term Government Bond ETF ( VGIT ).

Follow Trang Ho on Twitter @TrangHoETFs .