Fed On Pause: Buy IHY

Summary

• The Fed has announced its intention to put on pause its rate hike programme for this year, which bodes well for the fixed income space and the long-duration trade.
• While the global economy may be slowing down, we are not lurching towards a recession or crisis. As such, look into the high-yield space for yield.
• This high-yield ETF provides an attractive yield of above 5% per annum, and its diversified portfolio across geography and sector will help mitigate any concentration risk.

The Federal Reserve looks to be on course to slow down on their aggressive rate hike trajectory, as confirmed by Jerome Powell and Co in their first central meeting of the year this week. The Fed basically told the markets that it would be "patient" with its rate hike programme, presumably till macro risks such as the US-China trade war and Brexit abate. Simply put, markets should definitely not expect 4 rate hikes this year, à la 2018.

While we may not be on the brink of a recession, it appears the Fed is taking no chances and their stance is to swiftly arrest any slowdown the economy might be facing by keeping monetary policy easy.

Aside from the Fed, other central banks around the world do not appear to be on the cusp of a rate hike programme anytime soon. As such, lower-for-longer interest rates globally will likely support bond prices and should provide a more conducive environment for investors to increase exposure to longer-duration bonds.

The VanEck Vectors International High Yield Bond ETF (NYSEARCA:IHY) will likely be a beneficiary of this macro backdrop. As of 1 February 2019, the ETF holds a portfolio of 633 bonds that is diversified across geography and company sectors, with each holding comprising less than 1% of the overall holdings. As such, the potential impact of any issuer default on the overall portfolio performance is mitigated significantly. While the global economy may appear to be slowing down, we are not lurching towards a recession, and as such, the high-yield sector still looks attractive.

The ETF provides an attractive dividend yield of 5.83%, with its portfolio's yield to maturity at 5.32%. The expense ratio is inexpensive at 0.40%, and the portfolio's effective duration is at 3.83 years. As mentioned, with the Fed slowing down on its rate hike trajectory, I am comfortable taking on duration risk in my fixed income portfolio. Even then, 3.83 years is not uncomfortably long, which means the bond holdings are unlikely to take a significant hit even if the Fed decides to turn aggressive suddenly.

Geographical Breakdown

Source: Factsheet, 31 December 2018

The ETF is most exposed to China in terms of country exposures at 10.89%, as seen from its December 2018 Factsheet. The Chinese government has taken steps to reduce leverage in its financial sector, and while this may sacrifice economic growth in the near term, default rates of Chinese companies will be lowered in the long run.

Brazil (9.22%) is on the verge of emerging from an economic recession, and Bolsonaro has managed to lift risk sentiment with his promise of market-friendly policies. The UK (8.01%) looks increasingly likely to negotiate a softer Brexit scenario with the European Commission, either in the form of a pushing back of Article 50 or some form of transition agreement with the EU. Italy's (6.45%) populist parties have agreed to settle on a budget that will lessen the debt burden on the country, which has taken the markets by surprise.

All in all, I am comfortable with the diversified geographical exposures of IHY and with its top-ranked country exposures.

Sector Breakdown

Source: Factsheet, 31 December 2018

In terms of sectors, 28.5% of the ETF's holdings are exposed to the Financial sector. While approximately one-third of exposure might raise some eyebrows, I firmly believe that the banking sector is now more resilient compared to the 08-09 crisis period. Basel III will mandate all banks to increase their Common Equity Tier 1 ratios to at least 7% this year, which will place pressure on banks to focus on less risky businesses. As such, the 28.5% number may appear on the high side optically, but the risk of defaults within the sector is low.

IHY Price Chart

Source: Tradingview.com

As seen from the weekly chart of IHY above, the ETF has rebounded off supports around $23.50, and I am targeting the $25.50 level from a technical perspective. That is the upper end of the range IHY's price action has been largely contained within since 2015. Using an entry at the market ($24), a take-profit target of $25.50 gives an approximately 6% upside in terms of capital gains. This is, of course, not taking into account the 5+% dividend yield per annum in terms of income.

Overall, we might be seeing a pause in rising interest rates from the Fed, and other central banks appear unprepared to raise rates anytime soon. Such an environment is conducive for fixed income positions, especially those of a longer duration. The global economy may appear to be slowing down, but we are not lurching towards a recession or crisis - as such, I am comfortable looking within the high-yield sector for income. A 5+% income looks attractive compared to what I can obtain from the equity markets, especially with memories of December's volatility looming ominously high behind the recent New Year rally.

Analyst’s 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.