What Role Can Negative Duration High Yield Play in Investor Portfolios?

As we highlighted in a previous blog post, investors can use a variety of strategies in order to help reduce their portfolio’s interest rate risk. In this discussion, we focus on the potential opportunity for generating income from a high-yield bond exposure with negative interest rate risk. As one means of potentially capitalizing on the current market environment, we believe a negative duration, high-yield bond strategy may provide a valuable tool for investors concerned about rising rates. In our view, what investors seek from their bond portfolios is income, not necessarily interest rate risk. The WisdomTree BofA Merrill Lynch High Yield Bond Negative Duration Fund (HYND) can help investors preserve the coverage and breadth of familiar high-yield bond investments, while reducing their overall exposure to interest rate risk. As the first issuer of more traditional negative duration strategies in an exchange-traded fund (ETF), we believe that these products may provide investors with yet another tool to help reduce the interest rate risk of their overall portfolio while still providing current income. A History of Interest Rates and Drivers of Return For definitions of terms in the chart, please visit our Glossary.   Historically, interest rates have tended to rise as a function of a growing economy. Additionally, as shown in the chart above, in most of these periods of rising rates (shaded blue), credit spreads have tended to decline. One rationale behind this is that with stronger economic growth, borrowers may pose less credit risk to lenders. However, from a traditional bond investor’s perspective, gains from tightening credit spreads were oftentimes offset by losses from increases in nominal interest rates. In the case of a negative duration, high-yield exposure, investors could benefit from both sides of the trade: increases in interest rates and declines in credit spreads. Through the combination of a high-yield bond portfolio and a negative duration component, we believe that this integrated approach to fixed income may stand to benefit in a rising-rate environment as outlined above. For investors with a broader portfolio of interest rate-sensitive investments, a negative duration, high-yield approach may be a beneficial tool for maintaining current income and mitigating overall interest rate risk. How Does HYND Work? As shown above, HYND comprises a long portfolio of high-yield bonds and a short position of U.S. Treasury futures that target a negative 7-year duration. By taking a 20% allocation in HYND and the remainder in a traditional bond portfolio with a duration of 5.5 years, investors are able to reduce their net bond duration to 3 years. Although investors will generally be better off if interest rates don’t move or decline relative to an unhedged position, we believe that HYND provides a reasonable balance between current income and negative interest rate exposure. Should nominal interest rates rise in 2014 and credit spreads decline, HYND could provide investors with stronger returns compared to unhedged bond portfolios.