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High-Yield Bond ETFs That Limit Losses

Stan Luxenberg

NEW YORK ( TheStreet ) -- At a time when most bond funds have been sinking, high-yield exchange-traded funds have suffered especially big losses.

During the past month, SPDR Barclays High Yield Bond lost 5.7% while iShares iBoxx $ High Yield Corporate Bond declined 5.5%, according to Morningstar.

But new hedged ETFs have been limiting the damage by selling some assets short, betting that bonds will fall.

Among the top performers is ProShares High Yield-Interest Rate Hedged , which returned 0% in the past month.

Other hedged funds that have outdone conventional high-yield ETFs include Market Vectors Treasury-Hedged High Yield Bond and First Trust High Yield Long/Short .

High-yield funds, which hold bonds that are rated below-investment grade -- have suffered from an unusual one-two punch.

First, interest rates have climbed. Since the beginning of May, the yield on 10-year Treasuries rose from 1.66% to 2.58%. When rates rise, bond prices tend to fall as investors sell existing securities with low yields.

Second, investors have become nervous about risky investments of all kinds. As a result they have been dumping high-yield bonds. Since the beginning of April, investors have pulled $2.1 billion out of the SPDR high-yield fund alone, according to IndexUniverse.com.

To protect shareholders against difficult markets, the ProShares hedged fund starts by buying about 130 high-yield bonds, assembling a portfolio that tracks a Citigroup benchmark. Then the portfolio managers short Treasury bonds by selling futures. Whenever Treasury prices fall, the value of the futures increases. Gains from the futures lately have boosted the fund.

Instead of buying the ProShares fund, investors could achieve similar results by buying a high-yield ETF and combining it with a fund that shorts Treasuries. But that would require constant monitoring to make sure that one of the two funds did not surge and become overweighted in the portfolio.

ProShares makes matters easier because the fund constantly rebalances its portfolio so that the allocations to Treasury futures and high-yield bonds remain steady.

If rates continue to rise during the next year, as many economists expect, then the hedged funds should outdo the conventional high-yield ETFs. But if rates stay flat or decline, then the ProShares hedged fund is likely to trail.

When rates fall, bond prices tend to rise. That would hurt the value of the short positions held by the hedged fund. In a period of flat rates, the short positions would not provide any capital gains or losses. But selling short imposes costs because of brokerage commissions and other expenses. Those costs, which can range from less than 0.10% to 1%, are subtracted from total returns.

Although the ProShares and Market Vectors funds track benchmarks and always sell short, First Trust High Yield Long/Short has some room to maneuver because it is actively managed. First Trust portfolio manager William Housey currently has 25% of his assets in short Treasury positions. But if conditions warrant, he is free to reduce the short positions or remove them altogether.

Housey favors companies with relatively steady cash flows. Worried about erratic markets, he has been underweighting the lowest-quality bonds, which are rated CCC. "We have ended up with a little higher credit quality than you see in some of the passive funds," he says.

Worried that rates will continue rising, Housey has put 15% of his portfolio in floating-rate senior loans. The loans are made to companies that are rated below-investment grade. When rates climb, the interest payments on the loans adjust upwards. Because of their adjustable rates, the loans have proved resilient this year. "The loans have been the best-performing fixed-income class lately," says Housey.

Although Housey has been shorting Treasury bonds, he has not been shorting high-yield bonds. He says that he only shorts high-yield bonds during periods when defaults are rising. At the moment, default rates are low, and corporate balance sheets are solid. "Cash flows are relatively steady, and businesses are performing quite well," he says.

At the time of publication, Luxenberg had no positions in securities mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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