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 or paid off in 3.9 years. This figure has declined over recent years and is roughly a year longer than it was last year. There is, of course, a large range of maturity dates within the individual bonds as you can see below:
As you can see, just over a quarter mature within the next two years while most mature around 2024. This is known as the “bond maturity wall” which is a large amount of debt that is due soon. As yields have declined, companies have been able to refinance at more attractive levels which has enabled the wall to be pushed further and further back over the past decade. However, rates are unlikely to decline further which means companies will need to find ways to pay the piper.
High-yield bonds currently have a default rate of about 5-6% which is 2-3X higher than it is during normal economic conditions. A recent report from Fitch claimed that high-yield defaults are likely to remain at elevated levels through at least 2022. This will make it very difficult for many companies to achieve refinancing when most will need it. Most likely, this will cause many junk bonds will decline into lower rating ranges like CCC and below which places a significant drag on HYG.
This is the double-edged sword of low maturity dates. On one hand, they lower the principal value’s exposure to a change in rates (i.e duration risk). On the other, they create liquidity risks like this which have the potential to create an extreme spike in interest rates during a decline in economic conditions.
Is The Federal Reserve Saving Junk Bonds?
The high-yield bond market is not in a great situation. Defaults are at a ten-year high while yields are at a near all-time low. Such a paradoxical situation can only occur when there is artificial external support that is keeping the market from declining. The pace of Fed junk-bond purchases has declined to an unmaterial level, but the implied promise of support given a crash has allowed investors to buy these bonds regardless of their historically high risks.
This is a classic “‘Fed put’ moral hazard” which creates a large downside risk if the Fed’s support is not as strong as investors anticipate. Remember, the Fed is not currently buying any high-yield bonds and only promised to buy “fallen angels”, though they did buy a small amount in HYG and its peer (JNK) which own non-fallen-angels.
Importantly, the Federal Reserve is bound to many entities and its aim is not to simply keep risk assets from declining. Its stated goal is to encourage low unemployment while keeping inflation in check. They bought junk bonds in order to discourage large and highly indebted corporations from laying off employees. However, only $8.7B has gone into bonds with only a small portion of that being high-yield bonds. This is nothing compared to the $1.2T U.S junk bond market, much of which will be coming due over the next five years. It seems the market is assuming Federal Reserve’s support is much more far-reaching than it truly is. Overall, the recent rise in high-yield bonds is due to investors looking to ‘front-run’ the Fed and not the Fed itself as they’ve put far more money into the high-yield bond market.
The Bottom Line
The Federal Reserve’s support of high-yield bonds is truly very low. However, it has given investors the belief that there is an unlimited supply of money available to keep junk bonds from declining. This belief has inadvertently caused many investors to buy high-yield bonds thinking the Fed will indefinitely protect them from losses.
Time will tell, but this is probably a misguided view. Non-IG bond defaults are at a long-term high (and are expected to remain elevated for years) while yields are nearly at an all-time low. The magnitude of the Fed’s support is not as high as it would seem. Even more, there has been a considerable bipartisan backlash in congress surrounding the Fed’s decision to ‘prop up’ the corporate bond market.
Put simply, there are very few reasons to be bullish on the junk bond ETF HYG. Its yield is very low by historical standards and its risks are very high. Many companies it is lending to are struggling to make ends meet and, with maturities rising over the coming years, many may fail to repay the debt in-full. With defaults as high as they are, a wave of downgrades also seems likely.
Since it is unlikely HYG will rise (without rates becoming negative), I believe it is a solid short opportunity today. The short borrowing rate is currently only 30 bps. Short sellers must pay the 5% yield but that is far less than the expected 15-30%+ decline the fund may see over the coming months/year.
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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in HYG,JNK over 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.