2023-07-27 17:59:42 ET
Summary
- I expect junk bonds to face instability due to their artificially high prices and the potential for a recession.
- Despite HYG's impressive yield the risk-reward ratio is inadequate.
- I rate HYG a Sell due to its poor risk-reward ratio resulting from the fact that its yield is well below the historic trend line compared to 10-year treasuries.
Junk bonds are known for their high yields and high risk. Junk bonds, also known as non-investment grade or high-yield bonds, are bonds issued by companies that have a higher chance of default relative to their investment-grade counterparts. In the past year, junk bonds have been surprisingly stable during this extremely uncertain and volatile time in the market. I think this stability will come to an end in the near future and junk bonds will be hit hard.
iShares iBoxx $ High Yield Corporate Bond ETF (HYG) is a very popular junk bond ETF. In fact, it is the largest junk bond ETF on the market. HYG has AUM of about $15B and a 30-day SEC yield of nearly 8%. While this is undeniably an impressive yield, I don't think it's worth the risk. I rate HYG a Sell.
Holdings
HYG holds 1191 individual junk bonds and its top 10 holdings make up only about 4% of the AUM, making this a well-diversified fund. HYG does a good job of holding higher-tier junk bonds. Over half of the ETF is in the top tier of non-investment grade bonds, BB. About 37% is in B-rated bonds, just one tier below that.
HYG's holdings by credit rating (ishares.com)
While only about 10% of the AUM is in CCC and below rated bonds, I always like to point out that having any money in CCC and below rated bonds is a huge risk. Between 1994 and 2015, CCC bonds averaged an over 11% default rate, while the B-rated bonds, the notch up from CCC, only averaged a 2.8% default rate.
HYG has a weighted average maturity of 4.82 years. Its largest holding is in bonds with 3 to 5 year maturities.
HYG's holdings by maturity (ishares.com)
Junk bond prices are artificially high
Since the peak in 2021, the US junk bond market has shrunk by 13% as companies cut back on junk bond issuance when the era of historically low interest rates ended. I think the shrinking supply has caused prices to be artificially inflated. This goes back to basic economics. When supply shrinks, prices go up. Because funds such as HYG have to continue to buy junk bonds to reflect the market index, but the supply of these junk bonds is shrinking, it leads to them being forced to buy overpriced bonds. If we enter a recession and investors become more wary of the default risk associated with junk bonds, I think the floor could fall out and these artificially high prices will deflate.
These artificially high prices become more apparent when you look at the junk bond spread over US 10-year treasury bonds. The current spread is 3.9%. The average spread (historic trend line) since 1997 is 5.41%.
Junk bond spread over US 10-year treasury bonds ( currentmarketvaluation.com )
The current spread being 3.9% would seem to imply that not only are we in average economic conditions but that we are experiencing better-than-usual conditions. This is obviously not the case. The Fed has rapidly raised rates to the highest they have been since 2001, and we are still experiencing sticky inflation. There was yet another rate hike yesterday and the Fed made it clear that there is a possibility of more to come. The reason the spread is so small is because of the shrinking supply.
What this means for HYG
If junk bonds are overpriced, then obviously HYG is also. I think HYG investors who realize junk bonds are overpriced right now should cut their losses, and now isn’t a horrible time to do so. The floor has not fallen out yet. The chart below shows HYG's total return over the past 3 years.
HYG is up over 9% since its 2022 low. My advice would be to get out now while HYG is still overpriced rather than when it falls and becomes fairly priced.
Risk reward ratio
There is a very real possibility of a recession. This is a risky time in the market. Taking on junk bonds in this economic environment doesn't make sense in my view. You would be adding risk while getting a yield well below the historic average relative to treasuries. While the junk bond spread over US 10-year treasury bonds is a preferred way to measure how much junk bonds are paying relative to safe investments, in the current market environment it's valuable to also look at T-bills compared to junk bonds.
ETF/bond type | 30-day SEC yield/bond yield |
HYG | 7.94% |
10-year treasury | 3.64% |
SGOV (t-bills) | 5.31% |
The spread between HYG (junk bonds) yield and SGOV (t-bills) yield is 2.63%. You would be taking on substantially more risk for simply 2.63% more in yield. While SGOV does have much more reinvestment risk than HYG, Fed Chairman Powell tells us that we will have high rates for a couple of years before rate cuts start, meaning SGOV or another ultra-short t-bill ETF will also have a high yield for a couple of years. Right now, I think there's no reason to lock in these not-great junk bond rates.
When HYG becomes a buy
Now that I've explained why HYG is a Sell, let's discuss when it becomes a Buy. When the spread between HYG's yield and 10-year treasuries returns to around its historical trend, it makes it much more attractive. However, this isn't the only qualification. The spread must be around its historical trend AND we must be experiencing normal economic conditions. This would signify that junk bonds are no longer overpriced to me.
Conclusion
The price of junk bonds is artificially high and isn't accurately pricing in the current economic conditions. This leads to a lower yield, which is well below the historic trend line. Along with this, the risk-reward ratio is very poor in my view. HYG only pays 2.63% more than practically risk-free t-bills. I don't think the risk is worth it. I rate HYG a Sell.
For further details see:
HYG: Overpriced Junk Bonds Spell Trouble Ahead