Summary
- High-yield corporate bond rates have risen dramatically to nearly 8% due to the rise in Treasury rates and corporate bond spreads.
- HYG may benefit from a decline in real interest rates, slightly offsetting its recession risks.
- Due to volatility in energy prices, a rebound in inflation remains a risk factor to HYG and all fixed-rate bonds.
- Growing expected bank loan losses and elevated corporate debt levels suggest HYG's credit risk has risen.
- While HYG could undoubtedly fall further in value, it appears to offer a superior risk-reward profile to dividend stocks, preferred equities, and Treasury bonds.
The sharp rise in yields last year has made bonds far more attractive investment opportunities. For nearly a decade before 2022, bond yields were chronically low and fell well below the inflation rate in 2021. Last year was the worst year ever for the long-term bond market, as rising yields caused significant depreciation. However, those losses have created widespread yield opportunities that offer far superior returns to most stocks today. Of course, many bonds carry elevated risk due to the economic credit cycle and the potential for a rebound in inflation.
One interesting example is high-yield bonds, such as those in the popular iShares iBoxx $ High Yield Corporate Bond ETF ( HYG ). HYG pays a very high 7.95% yield today . Many investors may look at its TTM yield of 5.3%, not realizing that it is based on average past twelve-month returns before the spike in yields. The weighted-average yield-to-maturity of HYG's assets is 8.3% today, but its true yield is around 40 bps lower due to its expense ratio. The fund's yield is elevated due to the increase in Treasury bond yields and credit spreads due to slowing economic growth.
HYG is not a "low-risk" investment, but its yield may be higher than it has been in many years. If inflationary pressures decline and economic stability returns, HYG could see decent appreciation as its yield falls lower. Of course, the macroeconomic situation remains precarious, so that HYG could become a "buy low, sell lower" investment under certain assumptions.
Will Corporate Yields Continue to Rise?
I analyze bonds by breaking down their yield into the components which drive them. There are three components behind HYG's yield, which generally fluctuate independently: real Treasury rates (or interest rates after expected inflation), the expected inflation rate, and high-yield credit spreads.
The real interest rate component is greatly influenced by "hawkish vs. dovish" or "constrictive vs. supportive" Federal Reserve monetary policy biases. Today, that bias remains somewhat constrictive as they look to reduce inflationary pressures, but it is starting to shift away from that stance as the US economy shows signs of slowing. This pattern can be seen in the relationship between the real interest rate and the manufacturing PMI (a strong leading economic indicator). See below:
Generally, real interest rates are higher when the PMI is strong and vice versa. However, today real rates are still very high while the PMI is falling, indicating real interest rates may soon decline due to the slowing economy. If real interest rates fall back toward zero, as I suspect, HYG should theoretically appreciate by ~6.45% due to its 3.85 duration level today (or 1.68% X 3.85). Of course, a recession (or near-recession) that lowers real rates could also increase corporate credit spreads. HYG may not rise to that extent unless the economic slowdown is moderate and not harmful to corporate balance sheet stability.
The Inflation Target May Rise
The expected inflation rate component is primarily driven by energy and commodity prices, representing inflationary factors beyond the Federal Reserve's scope of control. For example, if energy prices are very high, there is very little the Federal Reserve can do to lower inflation, causing the long-term (or 10-year average) expected inflation target level to increase. This factor has significantly impacted interest rates over the past year. See below:
There are decent bullish and bearish arguments to be made surrounding oil prices. On the one hand, energy commodity prices have fallen over the past ~10 months due to a slight increase in production levels, moderated demand, and the release from the SPR reserve. These factors could continue to keep oil prices low. However, as recently discussed in " VDE: Energy Stocks Face Their Greatest Bull Market Threat ," US producers are cutting back due to falling profits, and the end of SPR withdrawals could push the market back into a shortage. Overall, I believe energy prices could rise even under a recessionary scenario due to ongoing issues in the supply market and geopolitical tensions. This would be mildly bearish for HYG since its yield could increase under a higher implied inflation target level, likely offsetting potential gains from a reduction in real yields.
Corporate Spread Risks and Rewards
The final component of HYG's yield is the corporate credit spread. Most of HYG's bond assets are in the BB (49%) or B (40%) credit rating categories. These segments are below-investment-grade (or "junk") but are at the top end of that category, not nearly as speculative as C or D-rated bonds. In my view, BB and B-rated bonds are preferable to higher-rated BBB bonds because BBB bonds can suffer considerable losses if they're downgraded out of the "investment-grade" category because many financial institutions (such as pensions) only invest in investment-grade bonds. Thus, BB-rated bonds have much higher yields with only slightly higher credit risk than BBB bonds.
Still, if economic conditions tighten and harm corporate balance sheets, bonds could suffer downgrades or elevated default risks. HYG's bonds are at higher risk of this today because bank expected loan losses are elevated, signaling credit tension in lending markets. See below:
Corporate credit spreads are very volatile based on various financial and economic conditions. In certain instances, such as 2015, corporate spreads rose mainly due to a crash in oil prices that caused many energy bonds to fall through the "high yield" category. That is an example of a non-systemic credit risk factor that is not a substantial long-term risk for HYG. However, because HYG has decent sector diversification today, systemic risks, such as a combined increase in banks' expected loan losses, are red flags for corporate bonds. Today, banks' expected loan losses are trending higher, signaling elevated credit risk. Obviously, many bank loans are consumer-oriented and thus do not directly relate to corporate debt risks. However, rising consumer credit defaults would eventually spread to businesses as people reduce discretionary spending.
Notably, nonfinancial corporate debt levels have risen faster than the GDP following the 2008 recession. Comparatively, household debt has risen at the same pace as the GDP, indicating the greatest change in solvency risk is likely in the corporate sector. See below:
Many corporations have abnormally high debt levels today after immense debt demand over the past decade due to ultra-low interest rates. Companies had managed to borrow at excessively high levels when interest rates were much lower. However, corporations are at considerable risk today because they must refinance that debt at a much higher interest rate. This is known as the "corporate debt maturity wall," which was pushed out for years but will soon come due as companies struggle to pay higher refinancing costs.
After spiking last year, corporate credit spreads on BB and B-rated bonds have consolidated in recent months. This may simply be due to an increase in investment interest due to their higher yields. Additionally, the moderation to inflation has improved concerns regarding aggressive Federal Reserve tightening that could increase corporate default risks. However, the most recent above-expectation inflation print has increased rate-hike odds, implying credit risks could rebound higher.
Putting it All Together
The corporate credit spread on HYG's bonds is likely between the average level for B-rated and BB-rated bonds, or approximately 3.6%. So, if we add the five-year real interest rate of 1.68%, the five-year inflation breakeven rate of 2.29%, and the 3.6% corporate bond spread, we arrive at a total of ~7.6% - very near HYG's forward yield today of 7.95%.
HYG is likely to appreciate if the components that make up its yield fall. In my view, real interest rates will likely decline due to slowing economic growth; however, it is less likely that the inflation breakeven rate will fall much further, and it could rise if energy commodities fall back into a shortage. Further, although corporate credit risks may decline, rising expected loan losses and the "maturity wall" facing corporate bonds signal consistently elevated corporate credit risks.
Broadly, these assumptions heavily depend on the probability of a recession and, more importantly, its potential depth and duration. A deep or prolonged recession could be problematic for HYG, whereas a mild "growth slowdown" may benefit it through lower real rates and inflation. In my view, while HYG's credit risks are elevated, widespread downgrades would only likely occur if the economy suffered a relatively significant shock. At this point, little data points toward a "huge shock," with most indicating a " prolonged stagnation ," which may not significantly impact credit risks in B and BB-rated companies.
Overall, I am neutral on HYG as numerous positive and negative factors could impact its price this year. HYG's yield may continue to rise (causing HYG to depreciate). However, I believe HYG is preferable to most dividend stocks today since it has a much higher yield than most "high dividend" stock ETFs today, such as ( VYM ), excluding the enormously risky dividend funds like ( SDIV ). Even if HYG declines further, I believe it saw its greatest losses last year and is unlikely to fall further than stocks if a recession occurs since its yield is already so elevated. Thus, I would not buy HYG yet, but it offers superior relative value to most dividend equities, preferred stocks , and long-term Treasury bonds .
For further details see:
HYG: 7.9% Yield Makes Junk Bonds More Attractive Than Stocks