It’s a question as old as time: How can investors get quality high yield while protecting themselves against rising interest rates?
Short-term bonds, CDs and other traditional income investment sources are paying pretty much next to nothing. After all, you can’t pay the mortgage on less than 1%. But if you go out too long on the maturity and duration scale to get a real livable yield, you’re going to get killed as interest rates rise.
This sticky situation has those seeking income looking at every possible way to gain a little yield.
Well, Wall Street’s latest trick for income seekers delivers on both fronts: protecting against rising interest rates and producing a high yield. A slew of long/short bond exchange-traded funds could be the saving grace in your fixed income portfolio.
Getting a Zero Duration
One of the cool things about ETFs is that they allow regular retail investors the ability to use some pretty sophisticated tools once reserved for institutional investors. Long/short portfolios have been a favorite trick of pension and hedge funds as a way to limit their exposure to one asset class, and now they’ve made it to the world of bond ETFs. Investors might want to put out the welcome mat.
The problem investors face is that bond prices and their yields have a negative correlation with each other. As the Fed raises rates, a portfolio of fixed-income securities will likely lose value. Bonds with longer maturities suffer more and the longer the maturity of the bond, the bigger that suffering is. That measure of sensitivity is called duration. Essentially, for every percentage-point gain in yield, a 10-year bond would lose roughly 10% in price, while a long-dated a 30-year bond would drop around 30%.
So if you buy a fund like the iShares 20+ Year Treasury Bond ETF (TLT) to get some real yield in this environment, you’ll end up getting crushed when Janet Yellen & Co. end their quantitative easing programs.
Long/short strategies help eliminate the duration worries.
These new ETFs will sell — or short — a position in various Treasuries. That short position provides some cushion as bond prices fall in the wake of rising interest rates. At the same time, these new ETFs will go long a position of high-yield (or junk) bonds to pick up some current big income. Essentially, the long/short format allows investors to eliminate much of the duration risk, while still getting a pretty high dividend yield. Portfolios can have their cake and eat it too.
Now, the ETFs aren’t necessarily a panacea; there’s still some duration risk. But that risk is severely reduced in the long/short ETFs. Interest rates have been on the rebound for most of the new year, but even if they head higher, they won’t spike 15% overnight. Meaning investors can sit back comfortably and enjoy the higher dividends.
3 Long/Short ETFs to Buy
Market Vectors Treasury-Hedged High Yield Bond (THHY): If you love index ETFs, THHY could be your first stop. The fund was really the first long/short treasury products launched and uses a sampling approach to track an index of 700 high-yield bonds. Currently, THHY holds 65 different junk bonds, while holding a short position in five-year Treasuries. That produces a duration of roughly zero. Meanwhile, THHY produces a healthy 4.15% dividend yield. Expenses for the Van Eck fund run a bit on the high side, especially for a bond ETF, but that’s due to the nature of the short Treasury position. THHY has an expense of ratio of 0.8%, or $80 annually for each $10,000 invested.
First Trust High Yield Long/Short ETF (HYLS): If you’re looking for a bit more “flair,” HYLS might be a better choice. Unlike THHY, the First Trust fund is actively managed and not tied to an index. That gives its managers the flexibility to go long and short a variety of bonds. Currently, HYLS has a short position in Treasury bonds ranging from 5 to 10 years and includes investment-grade and junk bonds in its long potions. The ETF also has several floating-rate bank loans among those long positions. While HYLS’ duration isn’t as low as THHY — currently 3.14 years — investors are treated to a much higher dividend yield (5.6%). Active management does mean higher expenses, though; HYLS charges 1.14% in fees.
WisdomTree BofA Merrill Lynch HY Bond Negative Duration ETF (HYND): Finally, if rising interest rates truly freak you out, HYND is for you. The new fund goes a step further by shorting treasuries so that the ETF would go up when rates rise. Basically, investors are gaining access to the same index as the $3.75 billion PIMCO 0-5 Year High Yield ETF (HYS) without the duration hassles. The HYND has a duration of negative 6.97 years. Now, the yield for HYND, 3.7%, is smaller than the other ETFs on this list. However, as interest rates rise, HYND’s share price will actually increase due to the negative duration. That gives it a portfolio total return element for an investor’s bond holdings. Another positive: HYND’s expenses are cheap at just 0.48%.
The Bottom Line
For those investors looking for higher dividend yields, these Treasury hedged bond ETFs could be some of their best bets in this environment.
As of this writing, Aaron Levitt did not hold a position in any of the aforementioned securities.