2023-06-23 16:14:39 ET
Summary
- High-yield corporate bonds have seen lower investor interest due to their perceived risk and lack of growth potential compared to other assets.
- The junk bond ETF HYG has outperformed its low-risk peers, but growing credit risks and a potential recession could negatively impact its value.
- Despite its higher yield and lower interest rate risk, HYG may face downgrades and lose more value than its yield over the next year.
Over the past two years, the high-yield corporate bond market has seen generally low investor interest. Compared to stocks, high-yield bonds have essentially no growth potential. Compared to investment-grade bonds, they're often seen as "too risky." Even more, although high-yield corporate bond rates are much higher today, they're not as high as the double-digit returns found in many riskier assets (such as mortgage REITs, BDCs, and option strategy funds), which I tend to believe are far too prevalent today.
There are two ways of looking at risk and returns. Some investors, if not most, weigh absolute risk and absolute returns, focusing only on investments with the appropriate target risk or return profile. In my view, it is generally wiser to focus on investments that may have a higher return than their risk. For example, in March, I argued that "junk bonds" were relatively attractive because their yields seemed abnormally high while their risks were mitigated.
Today, the popular junk bond ETF ( HYG ) pays an SEC yield of 8% compared to its TTM yield of 5.6%. This means that investors in the fund today are likely to receive an ~8% yield after expenses, much higher than last year due to the rise in interest rates. Further, HYG's 3-year standard volatility is about 9%, so its expected yield-for-risk (or dividend to annualized volatility) is relatively high at ~89%. This compares to the more significant bond ETF ( BND ), having a 4.6% yield with a 6.2% 3-year average standard deviation, giving it a lower yield-for-risk of 74%. Since the 2022 bond bear market, HYG has performed better than its "low-risk peers, seeing a ~14% decline. Comparatively, BND has fallen by 15% since then, while the "investment grade" corporate bond ETF ( LQD ) has lost ~20% of its value.
HYG's outperformance stems from its lower duration risk than lower yielding and longer maturity bonds. At the same time, HYG has many attractive qualities compared to stocks and other bonds, but growing credit risks could cause it to lose more value over the coming months. Notably, significant declines in manufacturing growth, chronically low consumer confidence, and tightening bank lending are all potential triggers of a negative wave for high-grade bonds. With this in mind, I believe HYG's future is likelier to be bearish than it has been over the past three months.
Hitting The "Great Wall of Corporate Debt"
Over the past decade, nonfinancial corporate debt levels have risen significantly. The nonfinancial corporate debt-to-GDP level was around the same before the 2008 Great Financial Crisis. That said, it is much lower than in its 2021 COVID peak; however, while the data is unavailable, companies had significant cash savings in 2021 due to excessive borrowing that year. Thus, "net corporate debt" ( nonfinancial ) is likely at or near a cyclical peak today. See below:
Companies aggressively increased borrowing during the 2010s for a few reasons, but the expansion of business activities is generally not one of them. In many cases, companies increased borrowings due to the extremely low-interest rates of that era, often using that borrowed money to buy back stock or even pay dividends. Corporations have often used shorter-term borrowings for that purpose, consistently refinancing that debt at low-interest rates as it neared maturity. Problematically, now that borrowing costs are around twice as high for most firms, they have a strong incentive to try to pay down that debt.
This "debt maturity" wall has been pushed back over recent years, particularly in 2020-2021, when interest rates fell dramatically. However, it will likely not be made back further due to the sharp rise in rates last year. Around $107B in speculative-grade nonfinancial debt matures this year, doubling to $248B in 2024 and rising again to $390B in 2025. Looking at all non-IG debt, around 21% will mature over the next 36 months, signaling a relatively high portion of companies may struggle to refinance without straining weak operating income levels. Due to this, S&P Global ( SPGI ) expects the high yield default rate to double to 4% by the end of the year and potentially rise further in 2024 (according to Moody's).
Of course, those outlooks are primarily based on the debt maturity wall, increased borrowing costs, and the immediate operating incomes of most impacted companies. These outlooks do not account for potential declines in operating incomes associated with growing recession risks. On that note, there are leading solid indications of prolonged economic growth stagnation or decline, most notably in the "contracting" manufacturing PMI (below 50), the near-record inverted yield curve, and chronically weak consumer sentiment. See below:
These data do not prove a recession will occur over the next twelve months. However, the low manufacturing PMI indicates that US goods companies are actively reducing investments in new goods and equipment (among other factors). Further, if sustained, the inverted yield curve forces banks to reduce lending as borrowing costs rise asymmetrically compared to lending returns. Of course, weak consumer sentiment has created a negative strain on consumer demand. It will likely continue to do so until real hourly incomes rise at a sustained pace (without being matched with higher jobless claims - as we're seeing today.
We should also be mindful that these data are so low, even with a nearly 50% price cut for crude oil over the past year. Oil is the primary driver of transportation costs, making it the most significant predictor of long-term inflation expectations. Given the substantial price cuts, US and overseas producers are looking to reduce production despite low US inventories, meaning oil may become much more expensive over the coming 12-24 months. If so, the Federal Reserve cannot safely provide stimulus to the market, potentially exacerbating risk in higher-risk assets like junk bonds.
The Bottom Line
Spreads on high-yield corporate debt have been stable over the past year, with most paying around 3% over the Treasury rate, compared to historical lows of 2% before 2022. Given this, HYG is hardly discounting its portfolio's increasing credit and downgrading risks. Luckily, the most significant debt focus is in BBB debt which is investment-grade (only 1.2% of HYG's assets), so HYG remains less risky than its "safer" peers like LQD - which are highly focused on BBB bonds. In my view, the BBB bond segment is the worst overall today because they'll decline the most if downgrades grow amid the confluence of negative corporate credit factors. That said, some bonds in HYG, particularly its speculative CCC-rated assets (9.3% of holdings), could face default over the coming year. However, most of HYG's assets are concentrated in the BB (51%) to B (38%) segments, having generally low default risk but ample downgrade risk in the event of a systemic recession.
HYG has no exceptionally high exposure to any particular sector. Its most extensive exposures are consumer cyclical and communications (22% and 17%, respectively), with consumer cyclical carrying exceptionally high recession risk due to chronically weak consumer sentiment. Most of HYG's assets are set to mature within five years, giving them a low duration risk of 3.7 - meaning a 1% rise in interest rates should cause HYG to fall by around 3.7%. The "lower-risk" LQD has a much higher duration of 8.5 due to its longer maturities and lower yield, so HYG remains far safer regarding interest rate risk than most other fixed-yield bond funds.
Overall, I still prefer HYG, and its analogs, to other bond funds, including investment-grade corporates, treasuries, emerging market sovereigns, and municipal bonds. These "junk bonds" have much higher yields, around 8%, than all the other major bond market segments and typically carry much lower interest rate risk exposure. Further, while HYG's corporate credit risk is higher than investment-grade corporate bonds, I believe the price impact of a recession will be higher on LQD because it has so many BBB bonds at higher downgrade risk. Since many investors and institutions categorically avoid "below investment grade" bonds, there is a large ~1.2% spread between yields on BB and BBB -rated bonds, meaning BB bonds pay a hefty risk premium, and BBB bonds may fall more if downgraded out of the "IG" category. As you can see below, this spread remains higher than it was pre-COVID:
While I prefer HYG to other bonds ( and preferred stocks ), I am relatively bearish on the ETF. Its yield is high primarily due to the rise in rates. At the same time, its spread to Treasuries is not as high as I believe it should be given the fundamental economic trend and, most importantly, the massive junk bond debt maturity wall from today through 2026. In my view, there is a very high likelihood that many of HYG's holdings will face downgrades over the coming year, meaning junk bond spreads could rise over the coming months as investors begin to adjust to waning expectations.
While I would not bet against HYG today, I am bearish on the ETF and expect it to lose more value than its yield over the coming twelve months. The fact that HYG has remained flat despite a rise in most stocks over recent months may be a sign that it is a higher-risk area in the market - a potential "canary in the coal mine." In my view, it will be much more attractive to invest in HYG once the market begins to panic regarding the recession and credit-related risks. Until then, I will be waiting on the sidelines, avoiding essentially all bonds for now.
For further details see:
HYG: Impending Collision With The 'Great Wall Of Corporate Debt'