Avoid ‘Hedged’ High-Yield Bond Funds

High-yield funds with rate hedges increase risk at worst possible time. (Photo by: MyLoupe/UIG via Getty Images)

Often, simpler is better in finance and that definitely applies in the case of “hedged” high-yield funds. These funds own high-yield bonds with interest rate hedges. The three that I know of are HYGH (Blackrock) HYZD (WisdomTree) and HYHG (Proshares).  These funds are all small (rightfully so in my opinion).  HYGH is only $0.3 billion, compared to HYG at over $15 billion. HYZD is $0.3 billion as well and HYHG is under $0.2 billion.

Hedged High Yield Funds Are Riskier Than High Yield Bond Funds

This seems counter-intuitive.  Shouldn’t a “hedged” fund be less risk?

The Realized 30-day Volatility Is Higher For The “Hedged” Product

Rate hedged high-yield vs. regular high-yield (source: Bloomberg).Bloomberg

The blue line is the realized volatility of HYGH and the yellow line is the realized volatility of HYG.  Not only is the realized volatility of the hedged product almost always higher than the unhedged product, that difference increased exactly when you need the “hedge” the most. Using realized volatility as a measure of riskiness – the hedged product is more risky than the unhedged product.

Another way to think about this is that you want a “hedge” to protect you to the downside.

Hedged High-Yield Has Under-Performed In Larger Sell-Offs

In May, when Italian bonds sold-off, sparking a traditional “risk-off” move in markets – the hedged high-yield product didn’t work – it in fact lost more as the hedged high-yield product was down almost 2% while regular high yield was down less than 0.5%.

Rational Reasons For Hedged High-Yield To Fail

High-yield bonds are a hybrid product, the are

  • Part bonds
  • Part equity

High-yield bonds tend to perform well, in terms of price and spread when the economy is improving.  It is quite common for high-yield bonds to increase in price even as treasury yields rise – if yields are rising because the economy is doing well.

The exact opposite is true (maybe even more true). High-yield bonds tend to decline in price when treasury yields are dropping rapidly. High-yield bonds need economic growth and are leveraged to the economy. When yields are falling because the economy is slowing, that is scary for high-yield bonds, so the hedged product loses on both the high-yield bonds and the interest rate hedges.

While these hedged products may offer some comfort in benign markets, they will amplify losses when the high-yield market is weak (and add to gains in a strong high-yield market). It is not a hedge – it is a separate bet – one that is better controlled by adjusting your allocation to interest rate sensitive bonds, rather than embedding it here.

My Personal Experience With Rate Hedged High-Yield

One of my best high-yield hedge fund clients is adamant – the best “hedge” for high-yield is to OWN treasuries, not be short them.  That is a strategy I have been able to employ multiple times both in high-yield and emerging markets.

I have worked with some clients recently where we have tried to identify the more interest rate sensitive high yield bonds (typically longer than five years, non-callable (or a lot of call protection), with high quality ratings/tight credit spreads. That has resulted in a hedge of less than half of what would be used in a “fully” hedged high-yield product – and it seems to be working well in terms of realized volatility and providing a hedge when rates rise without being overly punitive when risk-off moves occur.

Hedged high-yield is one of those seemingly smart ideas that isn’t actually very smart.

Comments are closed.