CHUNYIP WONG
Back in the fall of 2022, I wrote a cautious article on the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEARCA:HYG), warning that slowing economic growth will likely lead to rising corporate defaults and more pain for credit investors.
However, my prediction for an impending recession in 2023 failed to materialize, as the U.S. economy reaccelerated after an H1/23 slowdown (Figure 1), fueled in part by continued government largess.
Figure 1 – US Real GDP reaccelerated in H2/23 (BEA)
As a % of GDP, the U.S. federal deficit of 6.2% in 2023 was the highest on record, outside of a recession, pandemic, or war (Figure 2).
Figure 2 – GDP fueled by large government deficits (St. Louis Fed)
Putting aside whether this level of extraordinary deficit spending is appropriate, the economic implication is that it is extremely difficult for the U.S. economy to contract when federal government spending is so dominant.
Strong economic growth and the Fed’s Q4/23 pivot away from tighter monetary policy helped the HYG ETF defy critics like myself and deliver robust returns of 18% since October 2022 (Figure 3).
Figure 3 – HYG has delivered strong total returns since October 2022 (Seeking Alpha)
For forward-looking investors, is now a good time to invest in the HYG ETF?
Brief Fund Overview
For readers looking at the HYG ETF for the first time, the iShares iBoxx $ High Yield Corporate Bond ETF provides investors with passive exposure to the high-yield (“HY”) corporate bonds asset class by tracking an index composed of U.S. dollar-denominated, high-yield corporate bonds. Readers can think of the HYG ETF as the equivalent of the S&P 500 Index, but for high-yield bonds.
The HYG ETF is the largest high-yield corporate bond ETF, with $15.3 billion in assets. The fund contains over 1,200 securities and has an effective duration of 3.3 years (Figure 4).
Figure 4 – HYG portfolio overview (ishares.com)
HY Corporate Bonds Are Macro-Driven Assets
Without belaboring the point, investors in high-yield bonds need to focus on the key macro drivers of interest rates and credit spreads. All things equal, higher interest rates and credit spreads will act as headwinds to the HYG ETF, and vice versa (Figure 5).
Figure 5 – High-yield bonds are strongly driven by interest rates and credit spreads (StockCharts.com)
Most of the time, the impact of credit is larger than that of interest rates, as credit tends to fluctuate rapidly. For example, in early 2020, even though 5-year treasury yields plunged from 1.5% to almost zero, the HYG ETF suffered a large MTM drawdown as credit spreads blew out to 10% due to the COVID pandemic.
Interest Rates In A Holding Pattern
With respect to the current environment, after a reflexive short-covering rally in October and November spurred by the Fed’s pivot, long-term interest rates have stopped declining in recent months as inflation remains stubbornly high and may be reaccelerating (Figure 6). This may force the Federal Reserve to push out the timing for expected Fed rate cuts.
Figure 6 – Inflation readings may be reaccelerating (WSJ via Nick Timiraos’ X feed)
Flat-to-rising long-term interest rates will act as a headwind for the HYG ETF going forward.
Please Mind The Gap
However, the factor that most concerns me with respect to the macro environment is credit, as credit spreads have collapsed to near all-time lows (Figure 7).
Figure 7 – High yield credit spreads near all-time lows (St. Louis Fed)
This tightening move in credit is surprising, given that actual defaults have been trending upward since early 2022. In fact, if we overlay credit spreads with actual defaults, we get a worrisome gap between the two series (Figure 8).
Figure 8 – A gap has formed between actual defaults and credit spreads (Author created with charts from St. Louis Fed and S&P Global)
According to data from S&P Global, high-yield speculative-grade defaults were 4.5% in December 2023 and may head even higher over the coming quarters as companies finally succumb to higher for longer interest rates. Historically, the two series are highly correlated, as credit spreads are just the market’s estimate of the cost of default. However, since peaking in June 2022, high-yield corporate spreads have actually collapsed to near all-time lows, creating a large gap between expected vs. actual defaults.
In my opinion, credit investors are not being compensated for high and rising defaults, so I would urge caution in all credit-related investments.
Risk To Being Cautious
Of course, I could be wrong in my view on credit. Credit spreads may be a leading indicator and actual defaults could moderate in the coming months. However, at ~3% credit spreads and flat to rising interest rates, future returns from the HYG ETF will likely be far lower than in 2023, when the HYG ETF returned 12.4% (Figure 9).
Figure 9 – HYG historical returns (morningstar.com)
Conclusion
The HYG ETF has defied critics like myself by delivering strong returns in 2023, as credit spreads tightened to near all-time lows while interest rates stayed relatively flat.
However, looking forward, risks appear skewed to the downside as there is a clear gap between actual defaults and credit spreads. I urge investors to exercise caution with all credit-related investments, as I fear a normalization of credit spreads to reflect actual defaults will cause significant drawdowns in the HYG ETF.
