U.S. High Yield And The Fed

Includes: JNK, TLT
by: Evariste Lefeuvre

Returns of U.S. high-yield corporate bonds are usually inversely correlated to U.S. Treasury returns. This is mostly because, baring recession and a spike in default rates, returns are mostly driven by a contraction in spreads.

In addition, as the chart below shows, the turning point in high-yield returns are often leading indicators of a forthcoming underperformance of U.S. Treasuries.

Since early June, the correlation has spiked on the positive side: negative returns for both assets. Why?

The outperformance of T-notes (NYSEARCA:TLT) to Junk (NYSEARCA:JNK) is usually highly correlated with risk aversion (VIX) as can be seen below. However, the link here has vanished over the last few quarters. As can be seen, the VIX did not spike considerably in June 2013, failing to breach the peaks of May and December 2012.

The lower sensitivity of the HY sector to risk aversion is also highlighted in the chart below. As can be seen, for the first time in two years, the 3-month change in the high-yield credit default swap (CDX index) has disconnected with 3-month returns of high-yield bonds. It highlights that investors are not as worried about a rise in risk aversion (credit risk related to lower GDP growth for instance) or an increase in the liquidity risk, but rather by the forthcoming era of higher rates.

The resilience of U.S. GDP suggests that default rates are going to stay low for a while. Without being too complacent, the recent resilience of the VIX suggests that risk appetite remains well-oriented. In addition, the huge spike in long-term rates might be a one-off. It is not that bond volatility will fall, but markets seem to have accepted the idea of higher yields in the future. As a result, I would stay long U.S. High Yield now that the Fed has restrained some of the upward pressure on interest rates and bet on a return to the negative relationship between U.S. T-notes and U.S. high-yields bonds.

Disclosure: I 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.