Why I Will Likely Be A Buyer Of High Yield In 2016

yieldDavid Fabian:  By now you have probably read everything about the death of high yield bonds, the investor lockup at Third Avenue, and the risk that these “junky” assets pose to exchange-traded funds.  Believe me, the financial media is just getting started slicing and dicing this thing up.  Everyone loves to sink their teeth into an investment that is tanking.  It makes for great headlines and offers a curiously similar effect as gliding by an accident on the freeway.  Despite our best intentions, we all slow down to take a peek.

As an avid watcher and owner of ETFs, I have been closely monitoring the price action of the iShares iBoxx High Yield Corporate Bond ETF (NYSEARCA:HYG) and SPDR Barclays High Yield Bond ETF (NYSEARCA:JNK) this year.  These two ETFs represent the lions share of the below-investment grade fixed-income space, with combined assets of $25 billion.

HYG is now down nearly 10% from its 2015 high and currently sports a 30-day SEC yield of 7.20%.  That yield has been steadily rising as the price of the bonds in the underlying portfolio have been falling.

The biggest concern in this fixed-income sector has been the decoupling from U.S. equity markets.  The SPDR S&P 500 ETF (SPY) is 5% off its high and still in the middle of its 52-week trading range, while high yield bonds continue to make new lows.  That is uncharacteristic of the typical correlation between these two asset classes and has many wondering if stocks are going to follow lower or junk bonds will ultimately rebound.

You would probably be hard pressed to find anyone admitting to owning these investments at this stage of the game.  However, there are literally millions of investors who own some form of junk bonds.  That may be through direct exposure in a fund such as HYG or indirectly through diversified corporate funds, aggregate indexes, bank loans, or a multi-asset fund structure.  It’s become an ubiquitous part of the chase for yield over the last several years and far more common than most investors understand.

From a psychological standpoint it seems like we have gone from complacency to extreme fear in a hurry.  HYG peaked in April, yet the accelerated nature of the sharp sell off in the last six weeks has investors whipped up into a frenzy.  This is the inner monologue that I imagine has taken place in many heads this year:

HYG down 2% – “Bit of a sell-off here.  Time to add to my holdings.”

HYG down 4% – “Spreads are so juicy at these levels.  I’ll nibble on a little more”

HYG down 6% – “Well this turned ugly quickly.  Maybe I bit off more than I can chew.”

HYG down 8% – “Get me the hell out.  Cash is king.”

HYG down 9% – “Haha, who would be dumb enough to still hold this stuff?  Glad I sold down here.  Now I’m safe”’

HYG down 10% – “Wow, look at it still cratering.  Maybe I should go short….”

That last one made me cringe as I saw several probing articles and social media anecdotes pointing out funds that short junk bonds last week.  They certainly do exist, although if you are asking about them at this stage of the game, you are probably a little late to that trade.  That’s just my personal opinion – things can always get worse, and we may still face a high volume capitulation event before a true bottom is formed.

There are two important points that should be understood at this juncture:

1. This whole thing is probably not as bad as everyone has made it out to be.  The “bubble has burst” or “high yield is dead” is likely driven more by headline artists than true investors in this space.  We see the same type of sentiment and conviction when stocks go through a 10% corrective event.  It’s always the end of the world and yet somehow it’s not.

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