How To Access Junk Bonds As Rates Rise

High-yield corporate bonds are often of as vulnerable to rising interest rates, but some exchange-traded funds can help investors maintain junk bond exposure in the face of higher U.S. borrowing costs.

The WisdomTree Interest Rate Hedged High Yield Bond Fund HYZD can help investors mitigate interest rate risk while providing a source of income even as interest rates move higher. HYZD, which debuted in late 2013, provides an alternative to the traditional ways fixed income investors look to hedge interest rate risk.

Honing Into HYZD's Strengths

“All else being equal, investors typically reduce interest rate risk (as measured by duration) in three simple ways: reduce maturity, swap fixed coupon bonds for floating rate or decrease credit quality,” said WisdomTree in a note out Thursday. “Given that the market tends to require that riskier borrowers pay higher coupon rates than investment-grade (IG) borrowers, bonds with the same maturity tend to have a lower duration. Additionally, given that yields also tend to be higher, investors also have a greater amount of “cushion” that can be used to dampen losses from rising interest rates. Therefore, high yield tends to outperform as rates rise.”

What About Rate Risk?

For investors concerned about rate risk, HYZD makes sense. The ETF has an effective duration of just 0.06 years, according to issuer data. By comparison, the largest high-yield bond ETF has an effective duration of almost four years.

Even with a significantly lower duration, HYZD does not skimp on income. The ETF's 30-day SEC yield is 4.88 percent, which is not far off the 5.14 percent found on the largest junk bond ETF.

“If investors are seeking to protect their portfolio from rising rates by increasing allocations to high yield, we feel it’s counterintuitive to own a bond strategy simply because it’s going to lose less than an IG strategy,” said WisdomTree. “In our view, exchange-traded funds can be used as powerful tools to help isolate credit risk in a bond portfolio through interest rate-hedged bond strategies like HYZD.”

In terms of credit quality, just over 82 percent of HYZD's holdings are rated either BB or B. Just over 11 percent are rated CCC.

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