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The bond market has been selling off for a few weeks. While the sharp move in Treasury bonds (NYSEARCA:TLT) gets a lot of attention, I am now more focused on junk bonds. Junk bond yields are still near record lows (and prices near record highs). At these levels, the risk/reward for junk bonds is not favorable and they seem vulnerable to more selling. The catalysts for junk bond weakness are the spike in Treasury yields as well as the repricing of risk assets that is paving the way for wider spreads. In this article, I will look at the price and spread dynamics of CCC, B and BB rated bonds as well as the key junk bond ETFs. The junk bond market cracked and I expect further declines.

Outlook On The Bond Market

My negative outlook on the broader bond market is discussed in these previous articles:

June 2 - Selling Begets Selling: 4 Bond Market Cracks Threaten Rally In Risk Assets

May 26 - Will Bond Vigilantes Drive The 10-Year Above 2.06% After Confusing Fed-Speak?

Junk Bonds

Junk bonds, also known as high yield bonds, are the riskiest part of the corporate bond market. These bonds are considered to have a higher probability of default than investment grade bonds. The majority of junk bonds are rated CCC, B, or BB (CCC representing the most risk). Please see the appendix below for an overview of bond ratings.

Although junk bonds represent a higher probability of default than investment grade bonds, I am not too concerned about defaults in the near term. Default rates are low (source: A Junk-Bond Bubble?) and many companies refinanced their debt over the last few years. They pushed out debt maturities and lowered their interest payment. Also, companies that survived the financial crisis have benefited from the economic rebound since 2009. At some point the default rate will increase, but that is not my immediate concern. Instead, I am concerned that the sharp rise in Treasury rates is causing a repricing of yield-oriented and risk assets, including junk bonds.

CCC Bonds: The Long-Term View

The dynamics of CCC, B and BB bonds are similar and I will use CCC bonds as a proxy for the market.

The yield the CCC bond benchmark is about as low as it has ever been. Bond prices move in the opposite direction as yields, so the current yield on the benchmark represents record prices.

Based on the historic pattern, there is little room for yields to decline further. Therefore, the risk/reward outlook is not favorable at these levels.

(click to enlarge)

(Source: Federal Reserve Bank of St. Louis)

CCC Bonds Over The Last Year

Over the last year, the CCC bond benchmark yield declined sharply as prices moved up. However, the trend has been reversing since mid-May.

(click to enlarge)

(Source: Federal Reserve Bank of St. Louis)

CCC Bond Spreads

It is important to look at the spread between the yield on CCC bonds and the equivalent US Treasury bond. US Treasury bonds are considered the risk free rate. The spread represents the relative risk for CCC bonds.

The spread for CCC bonds is low by historic standard, tough it was lower toward the end of the last cycle.

(click to enlarge)

(Source: Federal Reserve Bank of St. Louis)

Over the last year the spread has compressed significantly. However, it started widening in mid-May.

(click to enlarge)

(Source: Federal Reserve Bank of St. Louis)

The low spread makes CCC bonds vulnerable. Since spreads are low, there is little room for them to compress further. Therefore, as the yield on Treasury bonds moves up, the yield on CCC bonds would likely move up as well. If the yield on CCC bonds moves up, then the price for CCC bonds drops.

Furthermore, there is also the possibility (and even likelihood) that the spread for CCC bonds will widen, which means the yield for CCC bonds would rise at an even faster pace than the yield on Treasury bonds. This would also result in a drop in prices for CCC bonds.

Considering the history of the CCC bond benchmarks as shown in the graphs above, there is a lot of room for yields to rise and prices to drop.

Treasury Bonds

The yield on Treasury bonds is an important factor driving the yield/price of junk bonds.

The yield on the 10-year Treasury bond has been rising. Since mid-May the rise has been especially sharp. A continued move up in yields in Treasury bonds could lead to higher yields (and lower prices) for junk bonds.

(click to enlarge)

(Source: Federal Reserve Bank of St. Louis)

Junk Bond Sentiment

Sentiment in the junk bond market seems weak. For much of the past year, investors rushed into junk bonds as they searched for yield. However, that trend is reversing.

The Wall Street Journal reported on June 13:

"Funds dedicated to low or "junk" rated U.S. company debt saw $3.28 billion of withdrawals in the week ended Wednesday, according to fund tracker Lipper, as investors reacted to uncertainty about the interest rate outlook. The big outflow came on the heels of record redemptions the data provider reported last week to the tune of $4.63 billion."

Junk bond managers are likely fearing further outflows, which may led them to sell some holdings and put further pressure on the junk bond market.

B and BB Bonds

The dynamics for B and BB rated bonds are similar to the dynamics for CCC rated bonds discussed above. The following charts show the yield and spread for the B and BB benchmarks over the last year.

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(click to enlarge)

(click to enlarge)

(click to enlarge)

(Source: Federal Reserve Bank of St. Louis)

Junk Bond ETFs

The two main junk bond ETFs are SPDR® Barclays High Yield Bond ETF (NYSEARCA:JNK) and iShares High Yield Corporate Bond ETF (NYSEARCA:HYG). For more information about them, please see here and here.

The JNK ETF tracks the Barclays High Yield Very Liquid Index and the HYG ETF tracks the Markit iBoxx USD Liquid High Yield Index.

The breakdown of JNK's holdings by rating is:

  • BBB or Higher 2.00%
  • BB 35.60%
  • B 46.52%
  • CCC or Lower 15.88%

The breakdown of HYG's holdings by rating is:

Despite the slight differences, the price action of JNK and HYG is very similar:

JNK Chart

JNK data by YCharts

The ProShares Short High Yield (NYSEARCA:SJB) is an inverse ETF that is a vehicle for shorting junk bonds. The SJB is intended to deliver the inverse performance of the Markit iBoxx $ Liquid High Yield Index. Inverse ETFs are not perfect shorting vehicles, so please see the SJB's fund information for more information about it.

Outlook

I had been short Treasury bonds (though various vehicles), but covered those positions today [Thursday] to lock-in gains. I still have a cautious/bearish outlook on Treasury bonds, but the short-term risk/reward is not as favorable anymore.

However, I am still short junk bonds. I am long puts on the JNK ETF that stand to gain in value if the JNK declines in value. I am also long the SJB, which is intended to gain in value if junk bonds decline in value.

My main reason for shorting junk bonds is that the spike in Treasury yields is leading to a repricing of many asset classes, especially yield-oriented ones. Junk bonds, which represent the riskiest part of the corporate bond world, seem positioned for further losses.

Junk bonds yields are near record lows (and prices at record highs). Junk bond spreads are very low, though not quite at record lows. These levels imply a very unfavorable risk/reward and the potential for price declines. Even if Treasury yields move back down in the near term, junk bonds may still be vulnerable if spreads widen.

Despite my negative outlook on junk bonds, I am not expecting an increase in defaults in the short term. This limits the potential downside move in the junk bond market. Junk bonds may not crash, but seem positioned for a further move lower.

(Please note that this is not investment advice. Shorting involves a lot of risks, which are not discussed in this article.)

Appendix

(click to enlarge)

(Source: Wikipedia)

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Source: Selling Begets Selling: Shorting Junk Bonds As Bond Market Dislocations Continue

Additional disclosure: I am long puts on the JNK that stand to gain in value if the JNK declines in value. I am long the SJB. I may trade any of the securities mentioned in this article at any time, including in the next 72 hours.