How to Best Invest in High-Yield With a Hedge

Amid expectations that the Federal Reserve will continue raising interest rates this year, some fixed income investors are growing skittish with high-yield corporate debt and the related ETFs.

Corporate debt is reaching its highest level since before the financial crisis, which has caused Moody’s to warn that substantial trouble is ahead for junk bonds when the next downturn arrives.

The iShares Interest Rate Hedged High Yield Bond ETF (NYSEARCA: HYGH) offers investors an avenue for sticking with junk bonds while hedging interest rate risk. The actively managed HYGH holds the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEArca: HYG), the largest junk bond ETF, as well as short positions in interest rate swaps.

Low Duration to Traditional Junk Bonds

HYGH significantly lowers duration relative to traditional junk bonds like HYG. The former has an effective duration of just 0.21 years compared to 3.80 years on HYG. The group of interest rate-hedged or zero duration ETFs hold long-term bonds but also simultaneously short Treasuries or Treasury futures contracts to hedge against potential losses if interest rates rise.

Due to their near-zero durations, the rate-hedged bond funds should show little to no sensitivity to changes in interest rates. These types of hedged-bond ETFs could provide suitable exposure to the fixed-income market in a rising interest environment ahead.

Related: ETF Investors Turn Risk-Off, Fleeing Toward Fixed-Income