2023-05-30 04:23:46 ET
Summary
- iShares Interest Rate Hedged High Yield Bond ETF is a complementary product to iShares iBoxx $ High Yield Corporate Bond ETF, aiming to capture credit spreads with a near-flat duration.
- HYGH has outperformed HYG and JNK in a rising interest rate environment but will underperform as rates decrease due to its interest rate swaps.
- The article recommends selling HYGH and buying into HYG for investors seeking U.S. high-yield exposure, as HYGH will face headwinds once rates start decreasing.
- HYGH has a negative convexity profile and only a 5.6% 30-day SEC yield as opposed to more than 8% for HYG.
Thesis
iShares Interest Rate Hedged High Yield Bond ETF ( HYGH ) is an exchange traded fund from the iShares family. The fund is focused on hedged U.S. high yield bond exposure. The vehicle is a nice play on its sister, unhedged fund iShares iBoxx $ High Yield Corporate Bond ETF ( HYG ). HYG is a cornerstone of portfolio construction for many market participants, and its AUM exceeding $15 billion is a testament to that state of affairs.
HYGH aims to be a complementary product to HYG, and is catered to capturing credit spreads only. HYGH has an almost flat duration, meaning that it is not supposed to make or lose money as interest rates rise, leaving only credit spreads as the main driver of profit and loss. Its performance since the beginning of 2022 clearly illustrates the build:
HYHG is actually positive on a total return basis (i.e. dividends included), while HYG and JNK are not. Again this is due to its hedging via swaps . Hedging via swaps is a method of reducing risk by entering into a contract with another party to exchange assets or liabilities, thus transforming fixed rate exposure into floating. In a nutshell, an entity can reduce or eliminate its interest rate risk via fixed for floating interest rate swaps. There is a slight cost associated with this, but the most important feature is the resulting lack of duration. That translates into a limited profit and loss impact as rates increase, but also when they decrease.
The fund yields only 5.6% versus more than 8% for HYG due to its hedges and its design. When interest rates will start decreasing HYHG will start to severely underperform as it will be held back by its swaps. The same way its interest rate swaps provided a positive boost when rates were rising, they will provide a headwind in performance as rates decrease. In our opinion we are around peak rates as we speak and we do not anticipate the Fed to hike to 6%. We are in the ' higher for longer ' camp rather than seeing a Fed going overboard tightening.
We are therefore inclined to Sell HYGH here, with investors who still want HY exposure being able to buy directly into HYG, and thus being able to capture the full boost that the fund offers via duration when rates will eventually start coming down.
Where are rates going?
Some analysts view the last Fed hike as the peak in this interest rate cycle, while others still expect one more in June . Irrespective, we think the forward SOFR curve provides a pretty good narrative:
The forward curve tells us that Fed Funds will not exceed 5.5%, which makes longer end rates also fairly contained. Unless one thinks rates are going much higher from here, the yield curve is close to being done in embedding the Fed hikes. We are not talking about 20 to 50 bps moves here that can severely affect leveraged rates players, but the overall levels for an ETF such as HYGH.
If an investor thinks 2023 will mark the peak in rates, and we are not going much higher from here (say 6% Fed Funds as an example), then being flat duration makes no sense anymore.
Analytics
- AUM: $0.12 billion
- Sharpe Ratio: 0.73 (3Y)
- Std. Deviation: 7 (3Y)
- Yield: 5.6% (30-day SEC yield)
- Premium/Discount to NAV: N/A
- Z-Stat: N/A
- Leverage Ratio: 0%
- Composition: Fixed Income - Hedged U.S. HY Exposure
- Duration: 0.05 yrs
- Expense Ratio: 0.51%
Performance
Given its elimination of duration and associated benefits, the fund lags long term:
We can see the vehicle severely lagging most of the past decade until the 2022 interest rate shock. This makes sense from a math perspective, since the ETF is paying away a portion of its cash flows to the swap counterparty. From a fundamental set-up perspective HYGH is meant to outperform only in a rising interest rate environment.
Holdings
As highlighted in the above sections, the fund has a large position in HYG and a number of interest rate swaps:
The composition is fairly straight forward and we like that. The fund does what it is supposed to in achieving a quasi-zero duration profile:
Please also note the negative convexity for this fund. As per their own definition:
Convexity measures the change in duration for a given change in rates. Positive convexity indicates that duration lengthens when rates fall and contracts when rates rise; negative convexity indicates that duration contracts when rates fall and increases when rates rise.
Conclusion
HYGH is a fixed income ETF. The vehicle aims to replicate the performance of the HYG fund, but with an embedded duration hedge. It has done that very well since the start of this interest rate tightening cycle, being up on a total return basis since January 2022, as opposed to deep negative performances for JNK and HYG. The fund has a low duration of only 0.05 years that has boosted its performance in the past year, but it will hold the vehicle back as rates decrease. We do not think the Fed will go overboard with its tightening, and we do not see Fed Funds at 6%. In a decreasing rates environment HYG will significantly outperform HYGH. We can observe that from their duration and current dividend yields (HYGH yields only 5.6% versus over 8% for HYG). We are of the opinion an investor is well served to Sell HYGH here and buy into HYG if U.S. high yield exposure is desired, given the headwind the analyzed fund will have once rates will start decreasing.
For further details see:
HYGH: Time To Sell Unless You Think Rates Are Going To 6%