now that Federal Reserve Chairman Jerome Powell warned of a potentially higher terminal fed funds rate and that the bond market has appropriately adjusted for this risk, we believe that the conditions necessary to signal spikes returns have been met. Recent data indicating a resilient economy also supports our view of a mild recession without a significant increase in corporate defaults. As such, we see high yield bonds as providing the best risk-reward ratio within the fixed income space for a medium to long-term investment horizon.
We start our coverage of the iShares iBoxx $High Yield Corporate Bond ETF (NYSEARCH:HYG) with a “Strong Buy” rating.
High-yield bonds setting up for historic gains
For investors looking for a balanced portfolio allocation, we see a compelling case for being overweight high yield bonds. Having suffered a disastrous year marked by heavy losses in the bond market due to aggressive monetary tightening by the Federal Reserve, high yield bonds are bracing for record gains that could outpace equity returns in the next one or two years. two years.
Not only do we see yields compressing as default risk moderates thanks to the resilience of the US economy, but we also expect the Fed’s long-awaited pivot to materialize in late 2023 and trigger a broad-based drop in yields.
As the accompanying chart shows, the Bloomberg US Aggregate Bond Index, which tracks the performance of a broad basket of US investment-grade government and corporate bonds, has tumbled -16% in so far this year. On previous occasions, when the index has posted year-over-year declines of over -5%, the returns over the next two or three years have often been quite spectacular. We certainly see the potential for double-digit returns for investment-grade bonds and even higher returns in the high-yield space.
Resilient economy keeping default rates under control
According to the latest Fitch Ratings Commentarythe agency expects US high-yield default rates to hit around 2.5%-3.5% in 2023. This forecast remains below the 21-year historical average of 3.8% and very down from the 5.2% rate set in 2020. High Yield YTD default rate currently stands at just 1.2% and is expected to move towards 1.5%-1.75 % at the end of 2022.
These forecasts are generally in line with our view of a mild recession without a significant increase in corporate defaults. However, despite this rather benign view of the economy, yield spreads have remained relatively wide (5%) due to heightened concerns about a deep recession.
As the economic outlook improves in 2023 and fears about inflation subside, we expect spreads to narrow accordingly, giving an additional boost to high yield bond yields on top of a general decline in yields.
iShares iBoxx $High Yield Corporate Bond ETF
Based on fund information provided by iShares, HYG seeks to track the investment results of an index comprised of high-yield corporate bonds denominated in US dollars. As of this writing, HYG is the largest and most liquid high-yield corporate bond ETF with $15.4 billion in assets under management, well ahead of SPDR Bloomberg Barclays High Yield Bond ETF (JNK) in second place at $8.5 billion. millions.
As of October 3, HYG’s portfolio had a SEC performance of 8.22% with an effective duration of 4.14 years, and a moderate expense ratio of 0.48%. This is an ideal duration for our purposes as we see peak returns for high yields in the next year or two.
While we recognize that short-dated bonds look attractive at the moment, we see higher yield potential in longer-dated bonds when the Fed finally changes monetary policy. Not only are longer-dated bonds likely to outperform due to greater sensitivity to changes in interest rates, they also give long-term investors the option to hold to maturity, avoiding risk. of having to reinvest at lower returns for the next two years. years.
HYG is also well diversified, with 1,218 holdings and no single exposure exceeding 0.5% of the portfolio. The majority (52.1%) of the fund’s holdings are ‘BB’ rated corporate issues in sectors including consumer cyclicals (20%), consumer non-cyclicals (13%), communications (18%) and energy (12%). ).
Trading metrics for HYG are also healthy with small spreads, high volumes and the fund trading very close to NAV. We note that HYG generally trades at a premium above NAV, but at the time of writing it trades at a slight discount.
High-yield bonds are poised for record gains that could potentially outpace equity returns in the next year or two. HYG is also a profitable ETF that will allow investors to rapidly increase exposure to high yield bonds and lock in an attractive 8.2% yield over the next two years.
We initiate coverage of HYG with a “Strong Buy” rating.