Everyone loves to sink their teeth into an investment that is tanking. It makes for great headlines and offers a curiously similar effect as gliding by an accident on the freeway. Despite our best intentions, we all slow down to take a peek.
As an avid watcher and owner of ETFs, I have been closely monitoring the price action of the iShares iBoxx High Yield Corporate Bond ETF (NYSEARCA:HYG) and SPDR Barclays High Yield Bond ETF (NYSEARCA:JNK) this year. These two ETFs represent the lions share of the below-investment grade fixed-income space, with combined assets of $25 billion.
HYG is now down nearly 10% from its 2015 high and currently sports a 30-day SEC yield of 7.20%. That yield has been steadily rising as the price of the bonds in the underlying portfolio have been falling.
The biggest concern in this fixed-income sector has been the decoupling from U.S. equity markets. The SPDR S&P 500 ETF (SPY) is 5% off its high and still in the middle of its 52-week trading range, while high yield bonds continue to make new lows. That is uncharacteristic of the typical correlation between these two asset classes and has many wondering if stocks are going to follow lower or junk bonds will ultimately rebound.
You would probably be hard pressed to find anyone admitting to owning these investments at this stage of the game. However, there are literally millions of investors who own some form of junk bonds. That may be through direct exposure in a fund such as HYG or indirectly through diversified corporate funds, aggregate indexes, bank loans, or a multi-asset fund structure. It’s become an ubiquitous part of the chase for yield over the last several years and far more common than most investors understand.
From a psychological standpoint it seems like we have gone from complacency to extreme fear in a hurry. HYG peaked in April, yet the accelerated nature of the sharp sell off in the last six weeks has investors whipped up into a frenzy. This is the inner monologue that I imagine has taken place in many heads this year:
HYG down 2% – “Bit of a sell-off here. Time to add to my holdings.”
HYG down 4% – “Spreads are so juicy at these levels. I’ll nibble on a little more”
HYG down 6% – “Well this turned ugly quickly. Maybe I bit off more than I can chew.”
HYG down 8% – “Get me the hell out. Cash is king.”
HYG down 9% – “Haha, who would be dumb enough to still hold this stuff? Glad I sold down here. Now I’m safe”’
HYG down 10% – “Wow, look at it still cratering. Maybe I should go short….”
That last one made me cringe as I saw several probing articles and social media anecdotes pointing out funds that short junk bonds last week. They certainly do exist, although if you are asking about them at this stage of the game, you are probably a little late to that trade. That’s just my personal opinion – things can always get worse, and we may still face a high volume capitulation event before a true bottom is formed.
There are two important points that should be understood at this juncture:
1. This whole thing is probably not as bad as everyone has made it out to be. The “bubble has burst” or “high yield is dead” is likely driven more by headline artists than true investors in this space. We see the same type of sentiment and conviction when stocks go through a 10% corrective event. It’s always the end of the world and yet somehow it’s not.
2. The same psychological cycle of greed and fear that we are accustomed to in stocks is going to take place in this fixed-income sector as well. It will seem cataclysmic and disastrous until it reaches a point where everyone who is going to has sold. That will be the inflection point that will ultimately create a sustainable bottom and drive prices higher. It may be in the form of a V-shaped reversal or a more rounded consolidation that takes months to stabilize and swing higher.
No one knows for sure when that inflection point may be. However, I’m closely watching technical indicators such as prior support levels, volume, sentiment, high yield spreads, and other key variables. These will be the pieces to the puzzle that give us some indication that junk bonds have turned the corner.
Rather than getting overly bearish at this juncture, I’m viewing the sell off as a long-term tactical opportunity. The key is knowing how this sector fits within the context of your diversified income portfolio and sizing your exposure correctly to your risk tolerance. My plan is to purchase an income-generating asset class at attractive levels relative to other bond alternatives. That’s likely a contrarian view right now, but in 2016 it may look quite different.
For now, I’m keeping my powder dry and my eyes open. I suggest that other serious income investors do the same and consider scaling into any new positions slowly over time. This will allow you the flexibility to size your holdings appropriately and use time or price to your advantage.
This article is brought to you courtesy of David Fabian.