HYG: The Fear Is Priced In

| About: iShares iBoxx (HYG)

Summary

The trailing 12 month yield is strong and combines with a sector allocation that only holds about 8% in energy.

Because oil prices continued falling in early 2016, lower exposure to oil is desirable to avoid risk of exceptionally high defaults.

I would expect positive returns from this point through the rest of the year due to how much fear has been priced in.

When I'm looking for a bond ETF, I normally want to see diversification in the holdings. The iShares iBoxx $ High Yield Corporate Bond ETF (NYSEARCA:HYG) offers diversification across sectors, credit ratings (within the junk category) and maturities. This is about as much diversification as an investor can ask for within the junk bond area.

Due diligence on bonds can be a fairly expensive endeavor and junk bond funds need to buy a substantial amount of different issues to create an adequately diversified portfolio. On the other hand some junk bond funds will try to keep expenses down by using indexing strategies and rely on a moderately efficient market to assure that they are buying a collection with a reasonable expected default rate for the prices they are paying to acquire the bonds.

Expenses

The expense ratio for HYG is .50%. Unfortunately the junk bond funds tend to have fairly high expense ratios so this is better than average. I'd love to see the expense ratios across the junk bond sector come down. That makes finding highly appealing junk bond ETFs significantly more difficult for me.

Mutual funds investing in this space tend to have expense ratios greater than 1%. I prefer a thoroughly diversified index with a .5% expense ratio to paying a high ratio. The fund tracks the Markit iBoxx USD Liquid High Yield Index. Since the inception of HYG they have underperformed the index by about .49%. That is an almost perfect match to the expense ratio .5%, so it is reasonable to say the fund is doing a pretty solid job of matching the index before expenses.

Yield

The trailing 12 month yield is 6.22%. The desire for a higher yield should be fairly easy for investors to understand. HYG is offering an exceptionally high yield that encourages some investors to take on the risk that the economy will turn worse and that defaults will start to mount. There is a very legitimate chance of the U.S. entering a small recession during 2016, but I wouldn't expect the defaults to add up to a high enough level to make HYG end up with a negative total return over the next 12 months. Due to the strong yield, even slight price declines can be overcome.

Duration

The following chart demonstrates the duration exposure for HYG:

Click to enlarge

The bond fund is heavily diversified in the maturities and brings both duration and credit sensitivities to the portfolio. The combination of both risk factors makes it easier to generate a strong yield and 6.22% in the trailing 12 months is very strong.

Since the Federal Reserve hiked rates in December, the market started to expect a strong series of hikes. After the substantial sell off we saw in January the earlier part of February the market expectations for rate hikes decreased substantially. The Fed Funds Futures predicts only a 33% chance that the federal funds rate will be higher than .50 after the December 2016 meeting (10 months out). The fed funds rate is already .50, so the consensus estimate is now for zero rate hikes.

With very low expectations for further hikes the yields on long term treasuries have fallen substantially. That trend has not carried over to junk bonds as investors are concerned about defaults and the fear over defaults has outweighed the rising prices (lower yields) in treasury rates.

Credit Risk

The following chart demonstrates the credit exposure for this bond fund:

This isn't too bad. A CCC rating is a sign that there is some fairly significant risks to the issue, but I wouldn't want to go overboard on panic unless they were also heavily exposed to energy bonds.

Sectors

The following chart demonstrates the sector exposure for this bond fund:

The fund is very heavily exposed to communications, but energy is only 8.6%. The importance of a low exposure to energy is a function of terrible oil prices. Since oil prices continued to fall early in 2016 the fair expectation should be for more downgrades to come through for oil companies and for defaults to occur on some of the weaker securities. I'd feel more comfortable here if energy was even lower as a percent of the portfolio. The yields are starting to get exceptionally high on risky oil bonds, but the risk is also exceptionally high. This fund is mostly carrying bonds rated BB to B with some CCC, but this is a junk bond fund not a "default bond" fund.

Conclusion

Overall the diversification here is pretty solid and I don't see much to complain about. This is a fairly large bond fund with $12 billion in assets under management. It offers good liquidity, and only moderate exposure levels to the energy sector which has proven exceptionally volatile over the last several quarters. If the expense ratio was lower, this fund would be hitting on all areas.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.