2023-09-24 07:32:43 ET
Summary
- The credit spreads are tightest since 2007 and likely to significantly spike over the next 12 months.
- The recent rise in real yields has not affected the junk bonds, as HYG has been flat over the last 6 months.
- The increase in real yields increases the probability of a recession and credit crunch.
What moves bond prices?
Bond prices are inversely related to interest rates - as interest rates increase bond prices fall. Thus, a bet on higher interest rates can be executed by shorting bonds, or bond ETFs.
But what causes the interest rates to change, or in this case specifically the bond yields?
The basic formula for bond yields is as follows:
Nominal yields = Real yields + Inflation Expectations + Credit Risk + Liquidity premium + Maturity premium
Treasury bond yields
Treasury Bonds, issued by the US Government, are considered to be Risk-free, meaning the Credit risk is essentially 0. Further, Treasury Bonds have been the most liquid asset globally, thus Liquidity premium is also 0.
Thus, Treasury Bond yields are affected only by 1) Real rates, and 2) Inflation expectations (relative to other bonds with the same maturity).
The nominal yield on a 10-year Treasury Bond has increased over the last 6 months from around 3.3% to 4.49%, as the chart below shows. What caused the increase in the nominal yield?
The increase in the nominal yield on the 10-Year Treasury Bond has been primarily driven by the increase in the real interest rate. As the chart below shows, the real rate, as estimated by the yield on the 10-year Treasury Inflation Protected Security ((TIPS)) has almost doubled over the last 6 months, increasing from just above 1% to 2.07%.
Inflation expectations, estimated as the Breakeven Inflation have been relatively stable over the last 6 months in a 2.3-2.4% range.
Thus, it's the real yield that is pushing the nominal yield higher. What is causing the increase in real yields?
The real yields respond to the supply and demand for Treasury Bonds, and can also be used as a monetary policy by the Fed. Specifically, the Fed can buy Treasury Bonds via QE to stimulate the economy by making real yields negative. The Fed can also remove the monetary policy stimulus by selling Treasury Bonds via QT, which can push the real yields higher.
Recently, the Fed has been implementing the QT, which can explain the rise in real yields from -1% to +2% over last year.
However, it was the Bank of Japan monetary policy tweak in July to allow long term rates to reach 1% that triggered the recent rise in the Treasury real rates, given the expectations that Japanese investors would start selling US Treasury Bonds. Note, the Japanese investors are the largest holders of US Treasuries.
Further, the US Government is running an unsustainable fiscal deficit, which has been increasing the supply of Treasuries - at the time when the demand is weakening. The July Treasury auctions were weak, which added to the price pressure and lifted the real yields.
Bond ETF performance
Given the rising US Treasury nominal yields, the iShares 20+ Year Treasury Bond ETF ( TLT ) has dropped by 14% over the last 6 months.
In fact, during this period many investors revealed their short bets on US Treasury Bonds, for example the Ackman's big short .
But what about Corporate Bonds, especially the Junk bonds? Based on the valuation formula above, the nominal Junk bonds yields are also pricing the Credit risk or the risk premium, in addition to the real yields and inflation expectations.
Stinkingly, as TLT dropped by 14% over the last 6 months, the iShares iBoxx $ High Yield Corporate Bond ETF ( HYG ) remained essentially flat, falling by only -0.05%.
How to explain the relative overperformance of HYG over TLT over the last 6 months, as the chart below shows?
Obviously, the recent episode of rising real rates did not increase credit risk for junk bonds. But more importantly, the increase in real yields did not affect the junk bonds, which actually means that the credit risk premium actually decreased over the last 6 months.
Did we witness a flight to safety to Junk Bonds over the last 6 months?
In fact, the interest rate spread between the BBB rated bond yields (one notch above the junk) and the 10-Year Treasury Bond yields has been narrowing, from 2.3% to current 1.66%, which is the lowest level since 2007.
Implication - Short HYG
The recent overperformance of Junk bonds HYG over Treasury Bonds TLT is likely an inefficiency - and HYG is likely to fall sharply over the next 12 months, in absolute terms, and relative to TLT.
First, the increase in real interest rates is increasing the probability of a recession, given that a rise in real yields is a monetary policy tightening tool - designed to slow the demand by reducing investment - and thus cause a recession to tame inflation. The Fed has not indicated a timetable to stop the QT.
Second, the increase in nominal yields increases the probability of a credit crunch as the higher yields meet the wave of the corporate bond refinancing needs in 2024 and beyond. This is directly related to the unfolding Commercial Real Estate crisis, which is likely to be the next shoe to drop.
Thus, Credit Risk is likely to sharply spike over the near term, as the higher real yields trigger a recession, and the likely wave of corporate defaults. Thus, HYG is a prime short at these levels, and given the recent overperformance.
Note, according to Seeking Alpha, HYG has 47% short interest, which means that it is already a heavily shorted ETF - the big short on Junk bonds is already in place, but it has not worked yet.
The soft-landing narrative is possibly continuing to support the Junk bond prices, and keeping the credit spreads tight. Thus, the Junk Bond short might need a trigger that invalidates the soft-landing narrative, a data point that confirms a recessionary scenario.
What's in HYG?
HYG is well diversified ETF with 1207 junk bond holdings. These are the top 10 junk bonds in HYG, totaling just above 4%.
For further details see:
The Next Big Short - Junk Bonds