HYG - HYG: Spreads Near Historic Lows Limit Room For Alpha

2024-01-04 12:38:54 ET

Summary

• iShares iBoxx $ High Yield Corporate Bond ETF has performed well, generating a total return of 13% since we initiated our bullish view in November 2022.
• However, we now see increasing risks that market sentiment may be getting ahead of itself and potentially bordering on extreme greed.
• Fed Funds futures indicate that traders are already pricing a 39% probability of 6 rate cuts (150 basis points) by the end of the year.
• HYG is no longer as deeply discounted and attractive enough to generate meaningful alpha in our view.
• Accordingly, we downgrade our "Strong Buy" rating on HYG to a "Hold".

The performance of the iShares iBoxx $ High Yield Corporate Bond ETF ( HYG ) has surpassed our expectations since we initiated our bullish view with a "Strong Buy" rating on November 7, 2022 . Since then, HYG has registered a total return of 13%, an impressive gain for a 14-month holding period.

HYG's strong performance was in line with our optimistic view on the U.S. economy as well as monetary policy, with the Federal Reserve (Fed) looking increasingly likely to nail that soft landing.

Although corporate defaults have risen as the economy continues to cool, corporate default rates remain well within historical norms due to strong balance sheets and increased regulatory oversight on lending standards. The chart below shows the spread between yields on the J.P. Morgan Domestic High Yield Index and comparable maturity Treasury bonds (grey line) and the corporate default rate (blue line). As we can see, default rates have clearly picked up steadily in recent months, but remain well within historical norms and nowhere close to levels seen during past crisis periods.

Option-adjusted spreads on the ICE BofA US High Yield Index show a similar trend, with spreads near historic lows at around 3.34%, indicating that sentiment towards the economy has turned significantly more optimistic in recent months.

From Extreme Pessimism To Extreme Optimism

We believe that optimism surrounding the prospects for monetary normalisation in 2024 may be the key factor driving down high-yield spreads. The prospect of imminent rate cuts and a resilient economy has drawn growing interest in high-yield bonds as cash-heavy investors look to lock in attractive yields with longer maturities. If expectations for lower rates had been driven by fears of a sharp recession instead, high-yield spreads would have widened.

However, we now see increasing risks that market sentiment may be getting ahead of itself and potentially bordering on extreme greed. According to the CME FedWatch Tool , Fed Funds futures indicate that traders are already pricing a 39% probability of six rate cuts (150 basis points) by the end of the year.

Major investment banks have also recently upgraded their outlooks for 2024. Morgan Stanley, UBS, and Goldman Sachs are all expecting the Fed to cut rates, with UBS among the most aggressive by penciling in as much as 275 basis points worth of cuts by the end of 2024 and expecting the first cut to come as early as March.

This is much higher compared to the Fed's "Dot-Plot", which shows a median forecast of four rate cuts (100 basis points) by the end of the year.

Narrowing yield spreads also means that high-yield bond investors are no longer being adequately compensated for taking on additional risk. As the accompanying chart shows, U.S. high yields have historically offered a spread of around 3% over corporate investment grade and 4.5% over Treasuries in the last decade. But investors are now only getting a spread of 2.5% and 3.5%, respectively.

To be clear, our outlook for high-yield bonds remains constructive for the next few years given that the U.S. is only beginning to enter a period of monetary normalisation, which we think will see the Fed fund rates move back toward the natural rate of interest of around 3.5% to 4.0% .

However, high-yield bonds are no longer as deeply discounted and attractive enough to generate meaningful alpha in our view. According to fund information provided by iShares , HYG's portfolio had an SEC yield of 7.27% with an effective duration of 3.31 years and an average yield to maturity of 7.62%. (This compares to the SEC yield of 8.22%, an effective duration of 4.14 years and an average yield to maturity of 8.69% when we first initiated our bullish view on HYG in November 2022)

Hence, we see an opportunity to take some profit on HYG, and to wait for better opportunities to buy the dips. We would not rule out the possibility that the Fed may attempt to rein in excess optimism on rates again by communicating with a more hawkish tone in the coming weeks. And this should provide an opportunity to catch HYG at a more attractive level.

In Conclusion

We see increasing risks that market sentiment may be getting ahead of itself and potentially bordering on extreme greed by pricing in more rate cuts than the Fed is communicating.

HYG is no longer as deeply discounted and attractive enough to generate meaningful alpha in our view.

Accordingly, we downgrade our "Strong Buy" rating on HYG to a "Hold".

For further details see: