New High Yield Bond Fund Hedges Out Interest Rate Risks

NEW YORK (TheStreet) -- There are several risks to investing in the bond market. The big risk five years ago was credit risk; the risk that companies would default. Many companies' fortunes have improved since the financial crisis and many analysts believe that risk of default has decreased.

Another form of risk to investing in the bond market is interest rate risk which is the consequence of holding longer dated bonds when interest rates move higher. As a rule of thumb the price on a 10 year bond will drop by about 8% for each percentage point that interest rates increase.

If an investor owns an individual bond when this happens then they can wait until maturity and get all of their money back at the bond's par value but they will be stuck with a bond that is paying them less than the prevailing market. With a bond fund there is no par value to return back to, a bond fund can go down and stay down.

It is with these risks in mind that Pro Shares launched the High Yield-Interest Rate Hedged ETF ( HYHG). HYHG is one of several recently listed ETFs targeting the high yield market and there have also been several funds that seek to hedge out the risk of rising interest rates and HYHG does both.

The fund has two strategies under the hood. One is simply a portfolio of high yield bonds. The average maturity is seven years and there are specific rules on how the bond portfolio is constructed. No more than 2% of the portfolio can come from the same issuing company. All of the bonds in the portfolio must come from issues that are at least $1 billion.

The largest sector in the portfolio is industrial service at 36% of the fund followed by industrial manufacturers 24% and energy at 17%. There are other smaller sector exposures including financials which only make up 4% of the portfolio.

The credit quality breakdown of the fund is 43% each in BB and B rated issues with the remainder in CCC or lower. ProShares is reporting a yield of 5.69% but the fund has only been trading since late May and only paid three dividends up to this point, any future payouts could be more or less than the current 5.69%.

The other strategy is of course the hedging which is done with Treasury futures. The hedge is constructed such that the combination of futures used approximates the seven year maturity of the bond portfolio. A short position in two year Treasury futures comprise 22% (subject to rounding) of the hedge, five year futures comprise 32% of the hedge an ten year futures account for 42% of the hedge.

The fund's literature makes it very clear that the risk it is targeting for the hedging strategy is interest rate risk. The price of the fund could still be influenced by other dynamics in the bond market like credit risk or the widening or narrowing of spreads to investment grade debt. There is a relationship, or spread, between the yields of various segments of the bond market. When spreads narrow that typically implies high yield debt is expensive and when spreads widen then high yield debt is typically thought of as being inexpensive.

The significance of this point is that if Treasury yields hold steady but yields on lower quality debt go up, a widening of the spread, then the hedge would likely be ineffective.

The expense ratio is a surprising 0.50%. That figure is surprising because the benchmark but un-hedged iShares iBoxx High Yield Corporate Bond ETF ( HYG)charges the same 0.50%. The two funds have different portfolios so from the fund issuer's perspective it may not be an apples to apples comparison but an investor who wants to add high yield exposure would probably look at HYG first and then seek out whether there are any alternatives that might better suit their needs.

At the time of publication the author held no positions in any of the stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

More from Bond Funds

Retirement Questions About Closed-End Funds? Ask Your Fund Manager

Retirement Questions About Closed-End Funds? Ask Your Fund Manager

Why These Countries Are Dumping U.S. Treasuries and What It Means for the Dollar

Why These Countries Are Dumping U.S. Treasuries and What It Means for the Dollar

Striking Options: Volatility, Crude Oil, & Equities

Striking Options: Volatility, Crude Oil, & Equities

Worried the Bull Market Is Over? First Grab Some Late Cycle Buying Opportunities

Worried the Bull Market Is Over? First Grab Some Late Cycle Buying Opportunities

What is an Expense Ratio and What Does It Mean for You?

What is an Expense Ratio and What Does It Mean for You?