Hedge with High Yield Bond Inverse ETFs
It’s no secret that the Fed’s ZIRP has forced yield-starved investors to take on more risk. Consequently, several high yield bond (also known as ‘junk bond’) funds have become popular over the last few years to meet this need. High yield bond inverse ETFs should become equally as popular once the bond bubble pops.
Bonds are considered ‘junk’ with credit ratings of BB or lower by Standard & Poor’s or Ba or lower by Moody’s. To compensate investors for more credit risk (higher default rates), they pay rising interest rates. Exchange traded funds such as JNK and HYG has democratized an area of the risk spectrum once utilized only by professionals. When the price of West Texas Intermediate crude oil collapsed in 2015, buying an inverse oil etf became a very popular investment strategy. A large amount of junk bonds are issued by oil and gas companies.
Consequently, this demand recently dropped junk bond yields below 7 ½%, as measured by the Barclays U.S. High Yield Index, the lowest level in six months. While high yield prices aren’t quite back to 2014 levels, when yields dropped to around 5%, they are still quite elevated.
Amazingly, that 5% level is close to the Federal Funds Rate prior to last decade’s financial crisis. In other words, the market optimism was ‘pricing’ junk rated debt like a risk-free asset (as measured by the federal funds rate.)
High Yield Bond Spreads
Finally, another sign of complacency among high yield investors can be seen in the BofA Merrill Lynch U.S. High Yield Option Adjusted Spread, which has dropped to 5.83. This gauges the yield an investor demands above a comparable U.S. Treasury bond to compensate for the additional risk. This is not too far from the 3.35 back in June of 2014. Putting this in perspective, in December of 2008 this spread rose to 21.82.
Those yields of 2014 will probably never be seen again. If they are, it is likely to be from the Federal Reserve buying them in some type of open market operation. But in the United States we believe this is doubtful. In the European Union, Mario Draghi has indicated that he will be purchasing corporate bonds as part of their quantitative easing program. The question is whether or not that has already been ‘priced in’.
Junk Bonds: Cracks in the Foundation
But there is a serious disparity occurring within the high yield corporate bond universe. While the prices for high yield bonds and junk bond ETFs keep climbing, the underlying covenant quality is deteriorating, a trend that has been continuing since 2011.
Moody’s just released their monthly report on high yield credit quality (for May), revealing a serious drop in overall covenant quality for high yield bonds. Their data came in at 4.56 from 3.80 in April. They rate the covenant quality on a scale of 1-5 (1 being the best, 5 being the worst).
New High Yield Bond Inverse ETF
Direxion recently launched its Daily High Yield Bear 2x Fund, symbol HYDD. This double leveraged inverse high yield bond ETF aims to deliver investment results of 200% of the inverse of the Barclays U.S. High Yield Very Liquid Index. The fund will have a Net Expense Ratio of 0.80%, which will be capped by Rafferty Asset Management, LLC until September 1, 2017 according to Direxion’s website.
It can be considered the polar opposite of the SPDR Barclays High Yield bond ETF (symbol JNK) because they each track the same benchmark, the Barclays U.S. High Yield Very Liquid Index. JNK is ‘long’ the index and the HYDD is ‘short’ (double leveraged daily inverse) the index.
Since inverse ETFs are designed as a short-term, tactical tool (intra-day optimally) they are best used after a run up in the underlying benchmark. And ‘risk on’ has certainly been the strategy when it comes to junk bonds. Even after the fallout from the Brexit referendum, the SPDR Barclays High Yield Bond Fund, ‘JNK’ closed at $35.10, up roughly 12% just from its $31.27 low in February.