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Ideal Hedge for High-yield Corporate Bonds?

| | Posted in: Bonds

A reader asked: “My investments of choice have always been ‘junk bonds’ – high yield corporate debt. I have hedged my ‘junk’ at times with short positions in the Russell 2000 Index and a long-term Government Treasuries Fund. Is there something better? What is the ideal hedge for low-quality, high-income corporate debt?”

There is probably no instrument that is an “ideal” hedge based on the definition of very low return correlations with high-yield bonds under all economic conditions. The return correlation between any two asset classes generally varies over time. Given that the dollar tends to be weak (strong) when interest rates are low (high) and when the economy is weak (strong), you might take a look at currency futures as a hedge.

For example, the correlations between monthly total returns for iShares iBoxx $ High Yield Corporate Bond (HYG) and monthly total returns for PowerShares DB US Dollar Index Bullish (UUP), iShares Russell 2000 Index (IWM) and iShares Barclays 20+ Year Treas Bond (TLT) over the period May 2007 through November 2009 (32 months) are -0.60, -0.52 and -0.37, respectively. The hedging power of UUP is more consistent than that of IWM for equal subperiods. However, the sample period is short for this type of analysis and there may be conditions under which UUP is not a good hedge for HYG. You might want to look at different hedges under different economic/equity market conditions.

Some of these specialized exchange-traded funds have not been around long. Instruments with histories spanning multiple business cycles would be preferable for backtesting.

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