Exposure to junk bonds: How much should you hedge?

Junk bonds

Junk bonds are high yield bonds issued by below–investment grade corporations. Due to the low ratings and high risk of default attached to these bonds, they’re popularly called “junk bonds.” Risks in terms of rating and default are compensated for by the high yields these bonds offer.

Given that an investor chooses to invest in such securities and take on high risk with a view to earn higher yields, it may be wise to hedge a proportion of the investment—if not all of the investment—against interest rate risk that could erode the value of a junk bond totally.

Investors in high-yield ETFs always have the option to hedge their exposure to an extent by opting for high-yield bond ETFs with lower average maturities and duration. For example, as can be seen in the chart above, the SPDR Barclays Short Term High Yield Bond ETF (SJNK), with an average maturity of 3.47 years and a modified adjusted duration of 2.10 years, is less sensitive to inflation rate changes (which causes interest rate changes) while also giving the benefit of high yields.

To what extent should you hedge?

The extent to which an investor should hedge his or her investment depends mainly on two factors:

1. Risk appetite of the investor: To what extent can the investor bear a loss on his or her investment?
2. Cost of hedging

It’s a simple trade-off. To hedge, an investor needs to invest in two securities with negative correlations. In other words, to hedge one investment, you need to make another investment in order to offset the risk of any adverse price movements. The additional investment involves a cost. This cost of hedging can vary with the securities you select to hedge your investment. Investing in inverse bond ETFs is a very effective way to hedge your bond exposure. However, their expense ratios go up as high as 0.95%.

Also, there’s no single hedge ratio acceptable to all investors. Simply put, a hedge ratio is the ratio comparing the value of an investment protected by a hedge with the size of the entire investment. For example, consider that an investor has an investment of $1,000 in a high-yield bond fund—say, the iShares iBoxx $ High Yield Corporate Bond ETF (HYG), which has its major holdings in companies like Sprint Corporation (S) and First Data Corp (FDC). Now, if the investor invests $500 in the ProShares Short 20+ Year Treasury (TBF)—which is an inverse bond fund—his or her hedge ratio would be 50%. So, depending on how much additional investment can be made and the expense ratio for that investment (especially for inverse ETFs), you can arrive at your acceptable hedge ratio.

So, how much you should hedge is solely up to you, as per your risk appetite and the cost involved in the additional investment required for the hedge. But, given the fact that it makes the entire investment worthwhile by limiting the downside, hedging is a very vital tool for the rational investor.

To learn more about investing in fixed income, see the Market Realist series Key strategy: Will deflation contain the bear market in bonds?