Why You Should Be Keeping An Eye On Junk Bonds
Over the past year, there has been a lot of talk of the bond yield inversion in which short-term rates offer higher yield than longer. This is often a sign that a recession is coming…
Of course, we can talk about lag effects, but guess what, it’s been 19 months since the first 50 basis rate hikes, 12 months since then the yield curve inverted and there is now no sign of recession anywhere in sight.
Maybe we need a better prognosticator…
Introducing high-yield bonds, also known as junk bonds, which are debt securities that are rated below investment grade by a credit rating agency. These bonds are typically issued by companies that are considered to be financially risky and they offer higher yields than investment-grade bonds as a compensation for the increased risk.
Some experts believe that high-yield bonds can be a “canary in the coal mine” for the economy. This means that they can be an early indicator of economic trouble. When the economy is doing well, companies are able to borrow money at lower interest rates and are more likely to be able to repay their debts.
However, when the economy starts to slow down, companies may have difficulty making their debt payments. This can lead to an increase in defaults on high-yield bonds, which can be a sign of a recession. There is some evidence to support the idea that high-yield bonds can be a canary in the coal mine. For example, the yield on high-yield bonds tends to rise before the start of a recession. This is because investors demand a higher risk premium when they are worried about the economy.
Additionally, the default rate on high-yield bonds tends to increase during recessions. However, it is important to note that high-yield bonds are not always a reliable indicator of economic trouble. There have been times when the yield on these bonds has risen without a recession occurring. Moreover, the default rate on high-yield bonds can be affected by factors other than the economy, such as changes in interest rates or changes in the credit markets.
Overall, high-yield bonds can be a useful tool for investors who are trying to identify early signs of economic trouble. However, it is important to remember that they are not always a reliable indicator of a recession.
Investors should also consider other factors, such as the overall economic outlook and the creditworthiness of the companies that issue high bonds, before making investment decisions.
Traditionally, businesses that had high capital costs and the need for borrowing to fund projects; such as energy, small manufacturing or real estate development, were especially vulnerable to raising rates as it put pressure on the ability to repay loans.
Now, we’ve recently seen regional banks and other lending businesses come under the microscope as their bonds have slipped to less than $0.50 on the dollar, suggesting there is rot under the surface.
As I discovered on Magnifi there are quite a few high-yield ETFs, but I’m going with the oldest and largest to give me insight to the market.
The iShares iBoxx $ High Yield Corporate Bond ETF (HYG) was the first mover in the high-yield corporate bond market. However, direct comparisons are difficult, as HYG’s underlying index factors in transaction costs, while others, following industry convention, do not. In sum, HYG is an anchor tenant in the ETF bond market.
HYG is an exchange-traded fund (ETF) launched by BlackRock that invests in U.S. dollar-denominated high yield corporate bonds with a maturity of at least one year and less than 15 years and a sub-investment grade rating from Fitch, Moody’s or S&P. The fund seeks to track the performance of the Markit iBoxx USD Liquid High Yield Index, by using representative sampling techniques.
Another popular high yield fund is SPDR Bloomberg High Yield Bond ETF (JNK), as one of the first to launch in the space, is a hugely popular high-yield corporate bond fund.
The ETF provides a liquid and more cost-efficient way to access high-yield exposure than investing in individual bonds. The index tracks publicly-issued USD denominated, non-investment grade, fixed rate, taxable bonds that have a maturity between 1-15 years. The underlying portfolio is one of the broadest in the segment, and the fund’s yield, duration, and credit risk tend to align with those of our benchmark. The ETF is rebalanced on the last business day of each month. JNK investors need to consider total all-in costs when making comparisons to other funds.
The upshot; keep a watch on these high-yield bond ETFs such as HYG and JNK, they might be your canary in the coal mine.
Magnifi allows you to pull up a side-by-side view of ETFs you are interested in taking a close look at. Take a look at HYG and JNK to see how they compare to other bond funds and how they correlate to the broad equity market, such as SPY.
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