This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Corey Hoffstein, co-founder and chief investment strategist of Boston-based Newfound Research.
It is no secret that high yield bond indexes have their fair share of exposure to the energy sector.
A quick peek under the hood of the iShares iBoxx $ High Yield Corporate Bond ETF (HYG | B-64) shows us that it still has a 12.8 percent allocation to the energy sector. In June 2014, it was as high as 15 percent.
So as demand for commodities crumbled and prices fell, projected revenue for energy companies also fell. Lower revenue, in turn, meant that the probability of default for noninvestment-grade-rated companies increased.
The highlight story has been the global commodity giant Glencore. With crumbling commodity prices, credit default swaps on Glencore—derivatives used to hedge against a default—rose above 8 percent. This implies a greater than 50 percent chance of default (assuming standard recovery rates).
And Glencore debt isn’t even considered to be noninvestment grade. HYG supposedly holds worse bonds.
Worst Over For Energy Sector?
With financial analysts starting to chime in that the worst may be over for the energy sector—and other commodity sensitive sectors as well—is it time to look at junk as a potential value play?
High yield can be very interesting for two reasons. First, it offers a relatively significant yield opportunity in a zero-interest-rate policy environment. Second, it can offer equitylike upside potential without necessarily taking on equitylike volatility. In other words, it does not just offer income; it can offer significant capital appreciation as well.
Looking at spreads, high yield may be a nice buy. Current spreads are sitting near three-year highs and in the 15th percentile over the last five years:
For a full picture, though, we need to rewind the clock further: