The U.S. economy exited 2016 with a reasonable head of steam and looks poised for accelerating growth in 2017 and 2018. In tandem, the Federal Reserve appears set to steadily boost interest rates. That creates a clear challenge for fixed-income investors, as rate-sensitive investments tend to fall in value when interest rates rise.
Still, one type of bond may actually prosper from that backdrop: Speculative grade—i.e. high-yield or “junk”—bonds often rally in a stronger economy thanks to lower bond default rates. These bonds saw a 5.6 percent default rate in 2016, due mostly to balance sheet stress in the energy and commodity sectors. With those sectors now benefiting from firming pricing, Moody’s Investor Services predicts the rolling 12-month default rate will drop to just 3.6 percent by the end of 2017.
While the high-yield sector's average yield of 5.2 percent—more than twice the yield of 10-Year Treasuries—may hold relatively strong appeal, they still carry the duration risk that comes with longer-dated bonds. In response, a series of hedged high-yield bond funds have emerged to eliminate or even reverse the impact of duration.
The Test Case
WisdomTree offers a pair of hedged high-yield ETFs—WisdomTree Interest Rate Hedged High Yield Bond Fund (HYZD) and the WisdomTree Negative Duration High Yield Bond Fund (HYND)—that help illustrate how such funds perform against a backdrop of rising rates and improving GDP growth.
The former fund adds short positions in Treasuries (and Treasuries futures contracts) to create a zero duration portfolio, while the latter takes a long/short approach that creates a portfolio with the equivalent of seven years of negative duration.
An easy way to think about duration is that every percentage point increase in interest rates impacts a bond’s value by the length of its duration. So a 100-basis-point increase in rates would cause a bond (or bond fund) with a duration of six years to lose six percent of its value.
With the 10-year Treasury yield having risen by nearly a full percentage point since July 5, 2016, it appears these two Wisdom Tree funds have delivered on their promise. As the accompanying table shows, hedging has helped both funds outperform proxies for the larger bond universe and for unhedged high-yield bond funds, with the negative duration fund delivering especially robust returns. The Vanguard and iShares funds in the chart are the largest in their respective categories:
Kevin Flanagan, senior fixed-income strategist at WisdomTree, notes that the two Wisdom Tree funds are built to tackle different aspects of the changing bond market backdrop. “You should think of the zero duration fund as more of a risk mitigator against the Fed’s move to raise short-term interest rates,” he says.