High Yield Bonds Up 13% In 2016 - What's The Early Look For 2017?

| About: iShares iBoxx (HYG)
This article is now exclusive for PRO subscribers.

Summary

The market cap sector weighting for HYG is far different from that of the SP 500.

Even though High-Yield and the SP 500 correlated over time, sector composition is far different.

There is likely more pain ahead across fixed-income in '17, all due to interest rates, far less due to credit.

One important analytical aspect to comparing corporate high-yield to the SP 500 is to look at sector composition and compare the two in terms of market cap weightings.

Here is how the HYG and the SP 500 compare by sector weightings, and noting the difference could influence how you weight high-yield in 2017. (The "normal" portfolio weighting for high-yield in a broadly-diversified fixed-income portfolio (and this is what I've seen looking at many asset-allocation models) is typically 5% - 10%.

Sector mkt cap wts HYG SP 500
Comm's / Telco 25% 3%
Energy 14% 7% - 8%
Consumer Cyclical/Non-Cyc 25% 22% - 23%
Technology 8% 20%
Bank / Fin / Insurance 7% 15%
Cap Goods / Indus / Trans 14% 9% - 10%
Electric Utility 3% 3% (all Ute's)


HYG sector source: iShares website

SP 500 composition: Thomson Reuters data

Using Thomson Reuters data and the blog written every weekend, here is the last "market cap vs earnings weight" post I did last July, which drilled down into SP 500 data.

So what's the point of the analysis ?

Even though the SP 500 and the Corporate high yield debt market are correlated over long periods of time, and many articles from high yield experts like Martin Fridson and other high-yield giants over the years show that corporate high-yield can earn investors higher "risk-adjusted" returns than the SP 500, just know what you own when you own a high-yield ETF like the HYG or a corporate high-yield mutual fund.

The Communications / Telco weighting in the HYG was somewhat of a surprise when looking at the HYG sector distribution. There are only 5 public companies within the "Telco" sector within the SP 500; thus I wouldn't be surprised if the sector was folded into the Technology sector in the next few years.

On the credit side, when sectors have high-yield debt issuance in this quantity relative to equity issuance (and "telco" within the SP 500 is dominated by AT&T and Verizon, both investment-grade credits in the BBB/Baa rating range) it usually means competition is intense and the growth prospects might be limited.

However, the key analytical metrics for corporate high-yield credits are cash-flow and cash-flow volatility, and the sector could do better under the Trump Administration and the Republican Congress as "net neutrality" is clarified.

Tom Lee, the great market strategist at "FundStrat" gave an interview on CNBC in the last few weeks on FastMoney and he mentioned that "Telco" was one of his favorite sectors for 2017, and my first thought was "telco is only 3% of the SP 500 by market cap" so perhaps the way to play telco deregulation, M&A and net neutrality, is through the corporate high yield market and ETFs like HYG.

Conclusion: Within client accounts in 2016, the HYG was repurchased in the first quarter after the commodity selloff and the drop in Energy earlier this year, but HYG was sold early in the 3rd quarter after commodities rallied off their first quarter lows.

The big issue in 2013 around corporate and municipal high-yield is bond-market liquidity, which has been severely curtailed with Dodd-Frank and the post-2008 financial institution scrutiny. High yield actually sold off in 2013 with the "Taper Tantrum" and the HYG is lower today than it was in 2013, even with the steady improvement in the US economy. I would expect that is due to the steady decline in Energy and commodity prices since 2013.

Can the HYG repeat a 16% total return in 2017? Personally I would think not, even though my own opinion remains optimistic for the SP 500 for 2017, and the reason is I do expect much higher interest rates in 2017, and it could cause dislocations for various sub-sectors within the fixed-income markets. In other words, high-yield currently has a zero weighting in client accounts more due to worry over sharply higher interest rates in 2017, rather than a concern over declining credit quality or higher default rates.

Corporate high yield gets much more interesting to me when the current yield on the HYG is 7% - 7.5% and higher rather than the current 5.5% - 6%.

In the 2001 - 2002 equity bear market and the nasty selloff in all things Tech, Telco and Communications, high-yield credit spreads peaked near 14% - 15%. In the 2008 - 2009 near market, high yield credit spreads peaked at 22% - 25% current yields.

I do think we are nowhere near those credit-driven scenarios, but think that higher interest rates and a bond bear market could have unintended effects even with the least-impacted markets like high yield.

If current yields on the corporate high yield ETFs like the HYG and the JNK, clients would likely see a 5% - 10% position added to accounts.

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.