High Yield Market Underweight Follow-Up

Includes: HYG, JNK, LQD, SJB, SPY
by: Peter Tchir

On July 6th I recommended selling high yield ETFs - HYG JNK - or buying SJB. At the time HYG was 91.37. It has closed as high as 91.73, fell as low as 90.33 and is back to 90.75. So the trade has been marginal but has worked so far.

Has much changed since then? A new bailout plan was announced in Europe with much fanfare. This had the short term impact of making sovereign debt trade a lot better, but that has been short lived and the countries are all drifting wider again. European credit continues to be very illiquid, in both directions. The move tighter was fast and furious with minimal trading, and the move back wider has been slower, but the liquidity remains low. So, the original premise that the problems in Europe would squeeze the high yield market remains intact.

The lack of upside for the high yield market remains intact as well. So many of the bonds are trading at very high dollar prices and to relatively short call dates that in spite of spreads looking wide, there is little if any appreciation left. The duration of the bonds is just too low to get a big positive return from spread tightening.

The ETF's are also paying out a coupon higher than they are yielding. That means that the prices do have to drift down. It is a game mutual funds like to play as they realize that most retail investors focus on current yield when they pick a fixed income. The rules allow them to pay out dividends based on coupon received rather than yield expected to be earned. This seems to apply to the ETFs, so focus on the yield of the funds, not the current income. Any time they are paying out more in current income than the assets yield, there will be a drift to par affect (though clearly from a return perspective the income counts). So my concern that high yield bonds have little price appreciation potential remains and has hopefully been better explained now.

Finally, I think there is a new concern. Today's GDP numbers were bad. No other way to look at it. Most of the data that has come out indicates little growth for the U.S. economy with some pointing toward contraction. Some of the European data has been equally bad. If the economy is doing less well, some individual credits may start having problems. In the end, high yield bonds are the riskiest part of the U.S. corporate credit structure and from talking to dealers, CCC credits have started to become more difficult to trade again. That does not bode well for the high yield market. Not only will alternatives like sovereigns appear cheap or cause global fixed income managers to shift money out of high yield, but now you may see real credit risk creeping into the market. This is another reason, and better reason to sell high yield.

So my opinion is now stronger. I would be selling out of high yield. Buy SJB or sell your HYG and JNK funds. The upside remains limited and the reasons to be selling high yield bonds are growing. I am not expecting a big move, but I think you could make 3-5% in a month versus risking 1-2% if i am wrong.

As a side note, don't forget that the ETFs have a selection bias. They are not indices. Unlike most stock ETFs which have to match the index they reference, the bond ETFs have some flexibility. It is my belief that at inflection points the bias is for these funds to accumulate inferior assets that are over-valued. If dealers are seeing weakness in particular sectors of high yield, but the ETF's are still receiving inflows, those sectors that are weak but not cheap disproportionately find their way into the ETF portfolios.

LQD still seems OK to me. I don't see too much spread pressure there, as the weakness in the economy is limited and is likely to hit a few overleveraged credits without impacting the higher quality ones at all. Also, the concern about high quality sovereign debt (France and U.S.) seems to have generated an interest in 10 year, highly rated corporates. Basically there is a class of investors selling some high quality sovereigns to buy high quality corporates. Currently they get paid more to own those, and feel better protected from a ratings and safety perspective than they do in the sovereign debt.

I remain short SPY and believe that any real problems in the high yield market would quickly flow into stocks, but I have shifted my balance and have covered some of the SPY short in order to be able to short the high yield bond market. The potential for a big rally in stocks still seems much higher than it is in the junk bond market.

Disclosure: I am long SJB.

Additional disclosure: I am short SPY.