2020 has been a historical volatile year for high-yield bonds even more than equities. The high-yield bond market crashed 23% in a matter of days in March and saw yields rocket to over 6%. Since then, the Federal Reserve has increased support for recently downgraded “fallen-angel” bonds which has caused most to climb back to historically low dividend yields.
The Fed’s support of below-investment-grade bonds creates a bit of a conundrum in markets. On one hand, there is a supply of money that can support the market if it drops again. On the other, the promise of support has caused risk premia to decline tremendously, causing junk bonds to be priced like higher-quality bonds during a generally poor economic environment. If it were not for belief in this support, junk bond ETFs like (HYG) would likely be trading at least 10-20% lower.
Importantly, that support will phase out as the Fed’s aim was to purchase recently downgraded ‘fallen angels’. Today, they’re really not buying any high-yield bonds. If the bonds in HYG continue to downgrade, they are unlikely to see any Federal Reserve support as they are all already non-investment-grade. This means that if there is another market sell-off, HYG will likely decline far more than it had in March. Quite frankly, the fund could see a 20-40% decline as it had in 2008. See below:
As you can see, junk bond yields are at an all-time low today despite the highly uncertain economic and political environment. This makes the ETF very risky, and as I’ll demonstrate, a crash in junk bonds may be the most likely scenario.
Low Maturity is A Double-Edged Sword
HYG’s weighted-average maturity length is much lower than normal at 3.9 years. This means that, on average, bonds in HYG must be refinanced