HYG: Fears Of Economic Pain Still Present

Summary

• The HYG ETF has rallied 6.88% from its 52-week low amid a dovish Fed.
• The yield curve still remains relatively flat, reflecting weaker economic conditions ahead.
• Markets are still anticipating a rate cut in 2020, indicating that recession fears have not completely vanished.

The iShares iBoxx High Yield Corporate Bond ETF (NYSEARCA:HYG) is up 6.88% from its 52-week low during the Q4 2018 market turmoil. While the high-yield space had a dismal year in 2018 amid fears that an overly hawkish Fed could end up inducing a recession, speculative-grade bonds have actually been rallying this year due to more dovish and accommodative guidance provided by the central bankers, which has eased market tensions lately. Though there are signs that a dovish Fed may not be able to inhibit economic conditions from worsening, in which case, the rally in the HYG ETF could prove short-lived.

Source: Yahoo Finance

Prospectus Review:

The HYG ETF tracks the Markit iBoxx USD High Yield Liquid Index as its underlying benchmark. The fund management uses a sampling indexing strategy, whereby they select certain high-yield corporate bonds that are representative of the underlying index and at least 90% of its portfolio is allocated towards these bonds.

The top 10 holdings of the fund include:

Source: ishares

Risk note from the prospectus:

Debt issuers and other counterparties may be unable or unwilling to make timely interest and/or principal payments when due or otherwise honor their obligations. Changes in an issuer's credit rating or the market's perception of an issuer's creditworthiness may also adversely affect the value of the Fund's investment in that issuer. The degree of credit risk depends on an issuer's or counterparty's financial condition and on the terms of an obligation.

The reason I have chosen this particular ETF is because, out of all the ETFs that offer exposure to the high-yield corporate bond sector, this fund has the highest assets under management (AUM) according to ETFdb.com, currently standing at $14.5 billion. I consider AUM as a good indicator for how successful the fund has been in implementing its strategy to deliver on its objectives for investors. The higher its AUM, the more investors have allocated their capital towards the fund due to effective management. The ETF also has the highest average trading volume at 26.3 million. Hence, this means that the ETF has a very healthy level of liquidity. This is a good indicator for how easily investors can buy and sell shares in the ETF. Therefore, the higher the trading volume, the lower the liquidity risks. Hence, while my current thesis on the ETF is bearish, it is certainly an appealing investment vehicle to keep under consideration during upward cycles.

Shape of yield curve relatively unaffected

On Jan. 30, 2019, Fed chairman Jerome Powell confirmed the Fed's willingness to remain 'patient' with rate hikes going forward. Markets believe the rate hiking process has been kept 'on hold', as Powell claimed that several "cross-current" issues were raising uncertainty. Though this is not the first dovish statement Powell has made this year, as he also expressed willingness to keep monetary policy conditions accommodative on Jan. 4, 2019. This has triggered a rally in risky asset classes, such as equities and high-yield corporate bonds.

However, it is worth noting that the Fed's dovish guidance has not helped steepen the yield curve, as it still remains relatively flat. While the 2yr/10yr section of the yield curve has not inverted yet, which would be a strong indicator of a recession, the spread between the 2yr and 10yr currently still stands at 16 basis points. This is a very narrow spread, which is reflective of weakening economic conditions ahead if not a recession. Moreover, the front-end of the yield curve is still exhibiting inversions, with the yields of the 2yr note, 1yr note, and even the 6-month bill, each trading above the yield of the 5yr Treasury bond (at the time of writing). Furthermore, the 1yr yield is also trading 4 basis points above the 2yr yield. An inverted yield curve is an indicator of worsening economic conditions ahead.

Therefore, Powell's strongly dovish statements have actually done little to ease economic concerns, as the treasury market is still reflecting deteriorating economic conditions ahead. These negative signals spell trouble for the high-yield corporate bond space, as default rates could be on the rise when the anticipated economic pain materializes. Hence, these concerning signals from the treasury market indicate that it may not be wise for long-term investors to buy into the rally in the HYG ETF.

Markets still expect a rate cut in 2020

CME Group's FedWatch is a widely followed tool that indicates the market's expectations for future rate hikes using 'fed funds futures' pricing data. While the probabilities of rate hikes this year are relatively muted following Powell's dovish guidance, it is worth highlighting that markets believe there is a 16.5% chance of a rate cut in December 2019 (at the time of writing). Furthermore, there is a 26.8% chance of a rate cut in January 2020 (at the time of writing). This reflects the fact that market participants still believe economic conditions will get worse from here (and could even potentially witness a recession) in about a year's time, which would require the Fed to ease monetary policy conditions.

Hence, given that Powell's dovishness has failed to eliminate concerns of the economic outlook, weakening economic conditions ahead could undermine the performance of high-yield bonds. As the probabilities of a rate cut in 2020 surges, investors will flee the speculative bonds space in order to minimize exposure to the riskiest asset classes, as these could suffer the most in case of an economic downturn. Therefore, it may not be a good idea to hold exposure to the HYG ETF as fears of an upcoming recession rise.

Bottom Line

Given that negative signals from treasury markets are still present, and markets are still expecting a rate cut in 2020, there is a good chance economic conditions could get worse from here, which would be concerning for risky asset classes such as high-yield bonds. Hence, the rally in the HYG lately could prove to be short-term and more sentiment-driven thanks to a dovish Fed, in which case investors should take advantage of the rally by selling out of the sector. I would not recommend buying into the HYG ETF at this point.

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.