2023-06-07 16:00:52 ET
Summary
- Junk bonds face significant risks from both potential economic scenarios: high inflation and rate hikes, or an earnings recession.
- Inflation is likely to remain high, leading to further rate hikes by the Fed, which will negatively impact junk bonds.
- Shorting junk bonds offers a put option-like payout, with limited risk and significant potential upside in the event of an economic downturn.
Thesis
Whilst many are discussing the possibility of an equity market crash or a potential for a larger correction in treasuries, the cross-section between equities and treasuries which is corporate debt is still little discussed. Within corporate debt, junk bonds specifically offer an interesting short trade for the reasons that the title mentions. Junk bonds have the worst of both worlds: they have the downside risk that equities have, in that if an earnings recession were to happen then the chance of default is higher on junk debt; at the same time, they have the same issue as treasuries which is interest rate risk. This puts junk bonds in a situation where both a bullish scenario in the economy is bad for them and vice versa. I'll lay out the different scenarios below.
Scenario 1: High Inflation And Rates Hikes Continue
This scenario is my highest conviction. Junk bonds face interest rate risk if rates go higher. Over the last year, we've seen the Fed hike rates far higher than what the market expects due to high inflation. Under this scenario the economy continues to stay resilient, but because of that inflation continues to stay high and more rate hikes from the Fed are needed.
Rates on T-bills act as a ceiling to junk bond prices going up. For example, if a one-year t-bill is going for 5% then no one would buy a junk bond with a one-year maturity going for 5%; the yield to maturity would have to be far higher to compensate for the risk and there will always be a natural floor on the rate of 5% so the bond has limited upside.
Higher rates can also bring about default risk as most bonds will have to be refinanced to pay off balloon payments on them. When refinanced the rate will be significantly higher. We've already seen these issues in the commercial real estate market where developers got mortgages at 2% on an interest-only basis, then when the time came to refinance to pay off the balloon payment then the rates were often in the high single or low double digits. Lenders might not be willing to provide another bond to pay the old one off as the higher interest rate might not let the business cash flow positively. In that case, a cash-in refinance would have to happen or there could be a full default on the bond. I don't think this risk is thought about enough by other market participants.
Scenario 2: Earnings Recession
This scenario is in many ways the opposite of the previous scenario. Here rates would collapse, but it would do so because of a deep recession which would significantly widen credit spreads and send junk bonds lower. In this scenario, the biggest risk would be default risk, not interest rate risk.
Scenario 3: Goldilocks Scenario
The third scenario is the only positive one that I see, which is what I would call the Goldilocks scenario. Here rates would be stable where they currently are but inflation would go down; this is the closest to a "soft landing" scenario and the only situation in which I find junk bonds to provide a positive return. I call this the Goldilocks scenario since it's not too hot (high inflation and higher rates) and not too cold (deep recession). Out of all the scenarios I find this the least likely as it requires what is close to a perfect equilibrium.
Inflation Is Here To Stay
I highlighted different scenarios above and in my opinion, the market is putting far too much credence on a "soft landing" which assumes that either inflation will quickly go below 2% or that the Fed is willing to ignore inflation to instead save the bond market from falling further. I don't believe either of these is true. The Fed has its reputation on the line and so far has shown that it doesn't want to let inflation run hot as it they've had the most aggressive hiking cycle in 40 years.
Let's take a look at CPI data from the BLS to break it down further than just the monthly headline numbers.
From what the data has shown us over the last couple of months the monthly rise has been consistent with 0.1%-0.5% being the monthly rise. This in and of itself shows that inflation seems to be stuck at the current level. But further inspection shows that inflation could even go up over the next couple of months.
The first reason is energy. Energy prices were at a very high level in early 2022 so naturally, the big pullback over the last year will look deflationary, but over time the Ukraine War spike in energy prices will start to come out of the year-over-year figures and this will raise the CPI. This also goes for all other commodities that went up in Q1 of 2022 due to the Ukraine War spike. In fact, due to us being in the northern hemisphere summer which is when both summer driving season and summer home building season are, I would expect to see higher demand for petroleum products; adding on to this both North America and Europe had a very mild winter season so gas demand was low; now though the summer time has shown to be hotter than average in Europe and will likely be the same in North America with El Niño expected to return. This makes it so that energy, which was previously an anchor keeping the CPI down, will now be a boon keeping it higher. Moreover, energy costs are a very large input into other costs like transportation costs, production costs, construction costs etc.
The second is rent. The CPI uses "owner's equivalent rent", which has steadily been going higher. The first thing to remember about rent is that it is lagging, both to the upside and to the downside. This is because leases are usually a year long and so it takes time for the cost of the landlord to be passed onto the tenant. The second thing to remember is that rents almost never go down. I haven't and most of you likely haven't ever seen a situation where a landlord gives you the lease for the next year and tells you that he/she cut the rent; it's one of those things that almost always go up unless there is a vacancy and the landlord needs to fill it immediately. The second thing to remember is that because rates have gone up the housing market is frozen. If you are a current owner of a home you aren't going to move to take on a higher rate and thus a higher payment. On the flip side if you are a renter then you aren't going to stop renting to buy a home as the mortgage will be unaffordable. This means that rate hikes ironically actually create more inflation in the housing market, and it provides landlords with the ability to further raise rents; often they will be forced to raise rents if they have a variable rate mortgage, or otherwise, they will be underwater on higher mortgage payments as they aren't getting enough from rent. The only real solution to this is for real estate prices to crash to make it more affordable to buy homes at higher rates or for rates to go back down. Till we see that I believe that we will continue to see high amounts of rent inflation.
Another area where we are seeing a rise in prices is used cars. Used cars went up in 2021 due to supply shortages. We are starting to see used cars go up again indicating that we could potentially see similar supply shortages to what we saw in 2021 as it is a sign that the consumer continues to have large buying power.
An example of this is used car prices which are up 5.5% in a month as shown in the below chart:
Assets like used cars are bought most often at this time of year, so it isn't surprising to see this rise and I expect it to continue throughout the summer driving season.
For all the reasons I mentioned above inflation of 4.5%+ is here to stay for the next couple of months and we will likely see the Fed hike over the next couple of months which will raise the floor on rates for corporate debt putting a ceiling on how high junk bonds can go.
If I'm Wrong
There are many out there who have the opposite belief that I do. They believe that rates will go down due to a recession. In this scenario, this trade will still work as even though rates are going down sending bonds higher, a recession will widen credit spreads to offset that. In past recessions, junk bonds do just as bad as equities do and they share similar downside risks. If you have this view instead I would recommend shorting HYGH - Interest Rate Hedged High Yield Bond ETF (HYGH) which is long junk and short treasuries futures . This is a pure credit spread play, so if we had a recession and credit spreads widened then HYGH would crash as it would get hit badly on both sides with higher treasury prices and low junk bond prices.
The biggest risk of me being wrong is the Goldilocks scenario. Most in the market call this the soft landing. In this case, inflation goes down, the economy is doing good, and rates are stable or lower. I think this is highly unlikely as most of these things are on opposite sides, in that if the economy does well then the Fed will use that opportunity to raise rates higher, and if they lower rates then it is likely because the economy isn't doing well. The other way the soft landing could play out is if the Fed is willing to ignore high inflation and still lower rates; in this process, rates would go lower and the economy wouldn't go into recession as the Fed has a "Fed put" on the economy. I find both these scenarios to be highly unlikely; the first due to the low probability of having a soft landing, and the second due to the Fed's unwillingness to cut rates with roaring inflation. If you do have one of these views though then this trade is to be avoided.
Shorting Junk Bonds Has A Put Option Like Payout
As I mentioned at the beginning of the write-up, junk bonds have the worst of both worlds. They have the risks of equities and of treasuries. What makes shorting junk bonds a more interesting trade than equities is the limited risk profile of shorting a bond. If you think that the economy will go into a deep recession and you short equities the risk to the upside is massive if wrong. There have been various instances of equities going up manyfold in a short period of time. An example would be April 2020, January 2019, March 2009 etc.
With yields on junk debt at around 8% (I use the above Bank of America High Yield Index), shorting junk bonds is like paying 8% per year in premium to buy a put option with the strike price being a DSCR of 1. DSCR (debt service coverage ratio) is EBIT to debt payments; as an example, a company with 100 in EBIT and 100 in debt payment has a DSCR of 1. When the DSCR is below one it means the creditors could be in trouble as there isn't enough cash flow to cover debt service, hence this is the strike price for debt default.
The Bottom Line
The bottom line is that junk bonds have the worst of both equities and long-dated treasuries, with the downsides of both, but share less of the upside. This creates a put option like convexity where a small carrying cost can be paid for a very large upside. SJB-ProShares Short High Yield ETF (SJB), which is a short High Yield ETF, can be used to put on this trade. Also, HYG-High Yield Corporate Bond ETF ( HYG ) or JNK-Bloomberg High Yield Bond ETF ( JNK ) could be shorted for this trade. Out of the three scenarios laid out above a soft landing scenario is the only one where this trade wouldn't work out. For those who are more worried about a recession causing rate cuts by the Fed, but with junk bonds still going down due to default risk going up, then shorting HYGH would be a better trade.
For further details see:
Junk Bonds: Stuck Between A Rock And A Hard Place