Short HYG: High-Yield Spreads Are Likely To Widen (NYSEARCA:HYG)

In this article, I offer a trade idea: short junk bonds with put options. I also suggest a hedging strategy that should help mitigate the cost of the trade. I think this is a very low-risk trade with big potential upside. After explaining the details of the trade, I will discuss the economic assumptions that underpin my recommendation.

As always, I would greatly appreciate any feedback, especially disagreements. If I’m wrong about something, I want to know. I don’t want to lose money any more than you do.

The Trade: Short High-Yield Bonds with “HYG” Puts

My investment idea is to short junk bonds. To me, this seems like such an obvious and low-risk opportunity as to make me wonder whether there could be something important that I’m missing.

As the graph shows, “option adjusted high-yield spreads” are approaching all-time lows. I expect this spread to widen sharply over the next 12 months. This will pressure junk bond prices and generate profits for anyone short these securities. I think this will prove to be a profitable trade on its own, but might also be an effective and inexpensive hedge for an equity portfolio.

I am buying put options on the iShares iBoxx $ High-Yield Corporate Bond ETF “HYG”. Premiums on these options are quite cheap. Implied Volatilities are only 6-9% compared to 12-15% for most equities. One can buy $100,000 in notional value of at-the-money HYG puts for $3,000 to $4,000. I have been buying at-the-money put options with 6-to-9-month expirations. These typically have a delta of around 50%, so in this example one would effectively be short $50,000 of HYG.

I suggest that you consider hedging at least some of your short HYG position by buying 3–5-year Treasury notes or related ETF’s. The average maturity of assets in the HYG is roughly 4.5 years, and its average duration is roughly 3.5 years. You could also write a put on a Treasury ETF. If you decide to write a put, be sure to buy a put that is further out of the money; as Nassim Taleb might say, be sure to cut off your tail (risk.)

There are two reasons to hedge your short position. First, you can defray the cost of your HYG premiums. If you buy Treasury notes, the interest you receive will pretty much pay for the HYG premiums. If you elect to write puts, the premium you collect will help offset the cost of your “long HYG puts.” As you can see from the graph, credit spreads can remain narrow for a long time before they reverse field.

A more important reason to hedge is that risk-free interest rates could decline, attenuating or even offsetting any gains made on HYG spreads widening out. This is very likely to occur if we enter a recession.

If you prefer, you could always write out of the money puts on the HYG. However, as noted above, premiums on these options are constrained. Moreover, as you can see from the graph above, expansions in high-yield spreads can be quite violent, and you wouldn’t want to miss such a move. Plus, if junk spreads do widen dramatically, it is probable that HYG options volatility will jump.

A more indirect way to hedge is to buy housing-related stocks (or write puts for premium.) Home building stocks are a good choice, but I prefer mortgage insurers and title insurers. If rates drop sharply, these will benefit from both new and existing home sales. Also, while I do not now own New York Community Bancorp. (NYCB), bear in mind that, with its Flagstar acquisition, it now has a very large nationwide mortgage operation.

Hopefully, our trade will work regardless of the ultimate economic outcome. If the economy softens, as I expect, I suspect that longer term interest rates may remain elevated due to the immense overhang of Treasury debt issuance and possible inflation concerns if the Fed eases sharply. But even if interest rates do collapse, our hedges should benefit while credit spreads widen.

If the economy were to strengthen, it is almost certain that longer term interest rates would rise, which will generate gains. As rates rise, think, it is extremely unlikely that spreads will narrow significantly further.

One cautionary note. When trading HYG options, or any illiquid option, ALWAYS use limit orders. While I have had no difficulty buying longer dated HYG options, they can have gaping bid / ask spreads.

Why are Credit Spreads so Narrow?

Frankly, I am puzzled by investor’s complacence about junk bonds, especially considering their recent freak-out about commercial real estate. Junk bonds have about the same refinancing risks as commercial real estate credit. Plus, Junk debt often has no collateral.

In fact, default rates on high-yield debt have already begun to rise. For empirical evidence, please refer to this SA article by Macrotips.

It is my hypothesis that junk yields are being suppressed by the overall “risk on” investment climate and a flood of liquidity into private credit funds that now have cash burning a hole in their pockets. But for reasons enumerated below, I think that this liquidity is about to become scarcer.

Furthermore, until very recently investors had been expecting DRAMATIC rate cuts by the Federal Reserve, which would have generated big gains in Junk bonds and mitigated refinancing risk. But clearly, short-term rate cuts will not be as dramatic as most expected at the start of the year (absent a crisis.)

Of course, it is possible that there is something more fundamental going on that is eluding me. I have heard many people contend that junk bond borrowers today are higher quality than they once were. I have been unable to corroborate this contention, but it certainly seems possible and merits further investigation.

But even if this contention is true, there could be an offsetting factor. Non-investment grade borrowing over the last few decades increasingly has been “covenant lite.” This enhances the borrower’s ability to further leverage as well as his bargaining position relative to the creditor.

The composition of the HYG does not seem to corroborate the high-quality argument. Consumer cyclical companies represent the biggest sector at 18% followed by communications at 16%, consumer non-cyclical at 12% and capital goods at 11%. I was surprised to discover that energy companies constitute only 12% of the HYG. I had thought energy’s share was much higher.

Credit Spreads are Likely to Widen

Of course, just because credit spreads are narrow does not mean that a gap wider is imminent. As the above chart shows, spreads can remain suppressed for a long time.

Still, I expect several forces to conspire to alter what has been a favorable credit environment.

First, I suspect the economy is not as strong as it appears to be. Before a slight recent uptick, leading indicators had declined for 14 consecutive months. I’ll admit that the most recent strong payroll number was a surprise to me. But even so, many employment indicators such a JOLTS and quits are declining.

Moreover, while the March payroll number was strong and shows jobs increasing by 3 million in the past 12 months, the household survey shows essentially zero growth.

Or consider this chart. It presents one of my favorite indicators; “workers employed part-time for temporary reasons.” As you can see, this metric has been an extremely good leading indicator of recession, with very few false positives. The number of part-time workers declines during economic expansions, but then begins to increase just before recessions.

I should emphasize that these days I have even less faith in economic (and political) surveys than I used to. For several reasons, there are serious problems with data collection. For instance, no one anymore answers phone calls from unfamiliar numbers. Plus, recent immigration trends probably distort some of these numbers.

Anyway, my primary reasons for expecting a slower economy hinge on Federal Reserve policy. I believe the Fed is primed to reverse its accommodative policies and turn more restrictive.

For many years, I have been deeply concerned about systemic liquidity. (see The Looming Liquidity Crunch). ). After flooding the system with a firehose of liquidity during the COVID crisis, the Fed in early 2022 began to remove liquidity through “Quantitative Tightening.” When this policy helped cause the failures of three large regional banks in March 2023, the Fed reversed course.

To be sure, the Fed continued “QT” but focused on paying off “Reverse Repo” debt while allowing bank reserves to grow (Bear in mind that in today’s topsy-turvy world, when the Fed raises the interest rate it pays banks on reserves, it actually increases reserves and eases liquidity conditions.) Since MMMF’s simply swapped RRP into newly issued T Bills, there was minimal impact on systemic liquidity. (I have borrowed much of this analysis from Stephen Anastasiou . I think he does excellent work.)

Today, the Reverse Repos are almost gone. If the Fed wishes to continue QT, it must start reducing bank reserves once again. This will drain systemic liquidity. As reserves decline, banks will be obliged to sell longer term assets to meet regulatory liquidity hurdles. Plus, of course, the continuing humongous government debt issuance will work to reduce liquidity, everything else equal. If the Fed elects to continue QT, it could precipitate a serious liquidity crunch.

But my biggest concern is expressed in the chart below. Traumatized by arbitrary and punitive regulation, bank lending is grinding to a halt. Since February 2022, bank loans have increased less than 2% (less than the rate of inflation) despite the near 20% year to year jump in reserves. Our bank bureaucrats have finally achieved regulatory nirvana; banks are refusing to assume any risk whatsoever. Absent a dramatic change in the regulatory regime, I see no reason why banks will begin to lend more freely.

As is widely recognized, much recent US credit growth has come from shadow bank and private credit sources. But remember that these entities cannot create deposits. They can only lend as long as they can borrow (or raise equity) from a 3^rdparty. Today, their business depends on excess systemic liquidity. At its core, new credit must ultimately derive from banks (or from the government itself, which is where much of today’s cash originated.)

I have borrowed these graphs from an excellent February 23, 2024 Federal Reserve report.. Note that even though private credit has increased dramatically, it is still less than 15% of total bank lending.

One final point. It is essential that investors keep an eagle eye on Treasury auctions. With immense issuance which will only grow and banks woefully constrained, I think that a “failed” auction is highly likely. In this event, longer term interest rates will spike sharply higher.