ETF Options to Hedge Growing Risk in Junk Bonds

Markets ETF Trends

Speculative-grade debt and junk bond exchange traded funds have strengthened as investors search for higher yielding assets in a low-rate environment. However, the greater demand has depressed yields, and some observers warn that high-yield debt may not be worth the greater risks.

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Year-to-date, the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEArca: HYG) rose 12.2% and the SPDR Barclays High Yield Bond ETF (NYSEArca: JNK) gained 12.9%. HYG now has a 5.42% 30-day SEC yield and JNK has a 5.82% 30-day SEC yield.

After the recent run in junk bonds, yields on speculative-grade debt are barely more than than higher-ranking bank lenders, who would typically get their money back first in the event of a default, reports Sally Bakewell for Bloomberg. The spread between junk bonds and more senior leveraged loans is the narrowest in two years.

This is “real risk on behavior,” Chris Remington, a money manager at Eaton Vance Corp., told Bloomberg. “If yields are comparable for two asset classes yet one has many more risks, the rational investors will choose the lower risk investment.”

Senior secured floating-rate bank loans are seen as a way for fixed-income investors to maintain yield generation while hedging rate risk. Senior secured floating-rate loans have, as their name suggests, a floating interest rate component, which fluctuates with market rates. Because rates are typically reset once per quarter, senior loans typically have low durations. Since the senior loans have rates that adjust periodically, the floating-rate loans also offer investors an alternative method of earning yields while mitigating interest-rate risk.

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For instance, the PowerShares Senior Loan Portfolio (NYSEArca: BKLN), the largest senior loan-related ETF on the market, has an average 45.09 day to reset period. Other options include the Highland/iBoxx Senior Loan ETF (NYSEArca: SNLN), and actively managed SPDR Blackstone/GSO Senior Loan ETF (NYSEArca: SRLN) and First Trust Senior Loan ETF (NasdaqGM: FTSL).

SEE MORE: Revisiting Bank Loan ETFs for Income

Investors have funneled over $2 billion into mutual funds and ETFs that track junk bonds over the last week of September, the largest deposit since mid-July, according to Lipper data. The rising demand was seen as a result of the Bank of Japan’s decision to keep yields near zero and the Federal Reserve’s lower expectation of rate hikes next year.

“The risk-reward is getting skewed,” Peter Tchir, head of macro strategy at Brean Capital LLC, told Bloomberg. “It’s a sign markets are not assigning enough risk to those high-yield bonds.”

SEE MORE: Investors Are Betting on a Pullback in Corporate Bond ETFs

Alternatively, investors may also consider inverse or short junk bond ETFs to hedge a dip in speculative-grade debt markets. The recently launched Direxion Daily High Yield Bear 2X Shares (NYSEArca: HYDD) tries to reflect the daily performance of -2x or -200% performance of the Barclays U.S. High Yield Very Liquid Index. Additionally, the ProShares Short High Yield ETF (NYSEArca: SJB) takes the inverse -1x or -100% daily performance of the Markit iBoxx $ Liquid High Yield Index.

For more information on the fixed-income market, visit our bond ETFs category.

This article was provided by our partners at ETFTrends.