LQD - JNK: At The Center Of A Credit Event

2023-09-27 11:22:37 ET

Summary

• We may be in a credit event, which is negative for SPDR® Bloomberg High Yield Bond ETF.
• Meaningful default risk can get priced in now.
• There will be opportunity in the JNK ETF afterwards.

Blessed are the young for they shall inherit the national debt. - Herbert Hoover.

Investing in high-yield bonds is a strategic move for many investors looking to diversify their portfolio and possibly achieve higher returns compared to traditional investment-grade bonds. But that comes at the risk of a credit event where default risk increases among highly levered issuers, ultimately then reflected in the price and yield of their bonds. High yield/junk debt is the bond market equivalent of the stock market, and when stocks sell off violently, so too does junk.

With that said, let's look at one of the more popular exchange-traded funds, or ETFs, tracking the high yield space as both a signal and potential opportunity AFTER a credit event takes place. The SPDR® Bloomberg High Yield Bond ETF (JNK) is an exchange-traded fund that offers investors a unique opportunity to gain exposure to the high yield bond market. The fund is managed by State Street Global Advisors, one of the world's leading asset management organizations. The fund seeks to provide investment results that generally correspond, before fees and expenses, to the price and yield performance of the Bloomberg High Yield Very Liquid Index.

This index measures the performance of publicly issued U.S. dollar-denominated high yield corporate bonds with above-average liquidity. These are often referred to as "junk bonds" because they are rated below investment grade and carry a higher risk of default. However, they also offer potentially higher yields, making them an attractive option for investors willing to take on a bit more risk for the potential of greater returns.

One of the more fascinating aspects of this environment is that despite going through the fastest rate hike cycle in history, JNK has performed remarkably well as credit spreads narrowed. When JNK outperforms Treasuries (of roughly similar duration), it suggests credit spread are narrowing. When underperforming, it suggests the opposite. Do you see what I see here?

JNK ETF: A Closer Look At Its Holdings

To get a clearer picture of what you're investing in when you buy shares in JNK, it's necessary to look at its holdings. The fund holds over 1,000 non-investment grade, fixed-rate, taxable corporate bonds with maturities ranging from one to fifteen years.

The portfolio is highly diversified, with its top ten holdings making up only a small percentage of the total fund. This means that the fund's performance isn't overly reliant on any single issuer, which can help to mitigate some of the risks associated with high yield bonds.

The fund's holdings are also spread across various sectors, with Consumer Cyclical being the largest. The diversity in sector exposure provides a balance and allows the fund to benefit from different economic cycles.

Evaluating JNK Against Its Peers

When considering an investment in JNK, it's also useful to compare it to similar ETFs. Comparable high-yield bond ETFs include the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) and the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD).

While each of these funds offers exposure to high yield bonds, there are differences in their portfolio composition, risk levels, and performance. For instance, HYG and LQD might have different sector allocations or credit quality distributions, which could lead to variations in their yield and risk profiles. Therefore, investors should carefully consider each fund's characteristics and how they align with their investment goals and risk tolerance.

The Impact Of Economic Conditions On JNK

The performance of JNK, like all high yield bond funds, is influenced by general economic conditions and market fluctuations. For instance, if the economy is strong and companies are performing well, the risk of defaults on high yield bonds decreases, which could boost the performance of JNK.

However, in times of economic downturn or heightened market volatility, high yield bonds are often hit harder than investment-grade bonds. This is because the companies that issue high yield bonds are generally more vulnerable to economic shocks. As such, the value of JNK can fluctuate significantly during these times.

With bankruptcy filings in the real economy surging, in my view it's only a matter of time until junk debt starts selling off, and potentially hard. I think we are there now. Conditions do favor meaningful spread widening.

Risks Of Investing In JNK

While SPDR® Bloomberg High Yield Bond ETF can potentially provide higher returns than investment-grade bond funds, it's important to be aware of the increased risk involved. The main risk is the higher default risk associated with high yield bonds. If a bond issuer defaults on their payments, it can lead to significant losses for the investors.

Moreover, high yield bonds are also more sensitive to economic downturns and market volatility. In times of economic uncertainty or market stress, high yield bonds can experience larger price swings compared to investment-grade bonds, which can lead to significant losses for investors.

Conclusion

While JNK offers diversification benefits and potential for higher yield, it also comes with significant risks, particularly in volatile or down markets. I would avoid SPDR® Bloomberg High Yield Bond ETF for a buy and hold here. If I'm right, the credit event has already begun, and there will be meaningful opportunity to pick up junk debt at much higher yields down the line.

Just not yet.

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