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:
The takeaway? High yield may be a value relative to where it has been in the last five years, but the last five years are expensive from a historical standpoint.
It’s like walking in to a store to buy a gift for your significant other. The clerk shows you a watch worth $1,000—now offered at the low, low price of $500. “What a steal,” you think.
Except if the clerk had just outright said the watch was $500 in the first place, you’d probably think it was expensive.
Things can be relatively cheap but still be absolutely expensive. That’s probably a good description of high yield today.
Consider the following drawdown graph of HYG:
We can see that from a statistical perspective, it is unlikely that HYG will go much lower. Most drawdowns stop in the negative 7.5 percent region.
Except when they don’t. That’s when we get the downside of “equitylike behavior”: equitylike losses.
So the trade-off today is to buy into something that is relatively cheap, but absolutely expensive, for an extra 100-150 bp of yield now being offered.
Opportunity Vs. Risk
In balancing this opportunity versus the risk, we believe a trend-following methodology can be useful. Our research shows that roughly 60 percent of high-yield return comes from yield, and 40 percent comes from capital appreciation (or, depreciation).
For income, we’re buying the yield. The volatility of repricing as companies default and credit spreads widen, however, is the risk we must control.
We believe that by using a simple trend-following methodology, we can identify those periods of time when it is safer to tap into the income stream without risking significant capital loss from price depreciation.
Today our momentum model still indicates a negative trend in high yield—a signal it has given for more than 12 months. Consistent with our core philosophy that capital preservation is a key objective, we are avoiding high-yield bonds until we see positive momentum return—which, according to our models, may actually be just around the corner.
Newfound Research LLC is a Boston-based quantitative asset management firm focused on rules-based, outcome-oriented investment strategies. Newfound specializes in tactical asset allocation and risk management solutions. Founded in August 2008, Newfound offers a full suite of tactical ETF managed portfolios covering global equity, U.S. small-cap equity, multi-asset income, fixed-income and liquid alternative asset classes. For more information about Newfound Research LLC, call us at 617-531-9773, visit us at www.thinknewfound.com or email us at [email protected]. For a list of relevant disclosures, click here.