Flight from quality: Investment rally is great news for high yield
Fixed income ETFs
The below graph reflects changes in popular fixed income ETFs since the 2008 crisis. As the bond market rally had softened and interest rates rose post-2013, long-duration bonds, as reflected in the iShares 20 Year plus ETF (TLT) have weakened. In contrast, shorter-duration bond ETFs, such as the iShares iBoxx High Yield Corporate Bond ETF (HYG) and the Barclays High Yield Bond Fund ETF (JNK), have largely maintained their value, while the highly diversified Vanguard Total Bond Market ETF (BND), with a mid-level duration exposure of approximately 5.5 years, incurred much smaller duration-related losses. Despite the decline in the U.S. labor force, consumption data has remained firm, and higher-yielding bonds have continued to perform well without incurring major credit-related losses. This article considers the trade-offs between high-quality, low-yielding fixed income opportunities and lower-quality higher yields in the current improving economic environment.
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To gain a broader understanding of the other macroeconomic factors supporting the economic and investment-related views in this series, please see Must-know 2014 US macro outlook: The crack in the debt ceiling.
Beware of risks: Credit quality
While the short duration aspect of both JNK and HYG might seem attractive to investors wary of rising rates, investors should bear in mind that both HYG and JNK also have significant credit risk embedded in their high yield and junk-rated bonds. Note that during the 2008 credit crisis, the AAA 20+ Year Treasury EFT and bond prices rallied strongly on a flight to quality, while on the other side of the credit spectrum, the BBB-B rated credit in JNK and HYG experienced significant declines. Similarly, in the other extreme set of circumstances—including rapid inflation or a sudden rise in interest rates—it’s also possible to see the credit component of HYG and JNK lead to underperformance of higher credit–rated bonds. Interestingly, the well-diversified higher-quality 5.5-year-duration Vanguard ETF (BND) exhibits much less volatility.
A credit comment: AAA and AA versus the below–investment-grade Sprint
Sprint (S) has a market capitalization of $36.17 billion (the value of all its equities), and it’s considered a high yield credit. Its debt is considered below the investment-grade cut-off of “BBB” rating, as it’s in the BB (junk bond or below–investment-grade) category. Reducing the firm’s $33 billion of debt by the $7.47 billion of cash holdings leaves approximately $25.5 billion of net debt, and a 1.29 debt-to-equity ratio. However, given the last quarter profit margin of -8.50%, the firm has seen a negative 18.48% return on equity. Sprint is a large company with $35.49 billion in sales revenue, and it still has $5.47 billion in earnings before interest and taxes (EBITDA) to service its net debt of $25.5 billion.
This is sufficient debt service capability, though a weakening economic environment in the USA could compromise the debt service ability in the future. With $48.57 billion in EBITDA and $42 billion in net debt, Verizon is clearly in a much stronger financial position than Sprint. Unless we see labor and productivity increases in the future, companies with weaker earnings margins like Sprint could face further pressures on their bond prices and higher yields.
However, the 2013 Softbank merger or acquisition and capital infusion of $5 billion may also improve Sprint’s credit outlook and operating health going forward. While Sprint is in fairly stable condition, it’s not as strong as its competitor, Verizon (VZ), with relatively lower debt levels and more cash on its balance sheet.
Below–investment-grade credits offer higher yield, with Sprint’s (S) August 15, 2020, bond yielding 5.35%, Valeant’s (VRX) October 1, 2020, bond yielding 5.34%, T-Mobile US’ (TMUS) April 28, 2020, bond yielding 5.01%, and CIT Group’s (CIT) May 15, 2020, at 3.98%. The investment-grade Verizon’s (VZ) September 15, 2020, bond yields a much lower 3.03%, and the CC rated Caesar’s Entertainment’s (CZR) February 15, 2020 bond yields around 11.37%. Overall, given CIT’s EBITDA relative to debt, it would appear to be a fairly solid credit, and may be worth the extra 1.00% yield over the high-quality Verizon, should investors be interested in incremental yield (Bloomberg & Capital IQ, December 31, 2013, Quarter).
To see how ultra-short-duration fixed income ETFs with lower credit quality exposure compare to longer-duration fixed income ETFs with higher credit quality, please see the next article in this series.
For additional analysis related to other key fixed income ETF tickers, please see the related series A flagging consumer price index contains the bear market in bonds.
Outlook: High credit quality and longer duration (TLT & BND) versus lower credit quality and mid duration (HYG & JNK)
For fixed income investors concerned with rising interest rates and falling bond prices, long-dated (long duration) ETFs such as the iShares 20+Year Treasury Bond ETF (TLT) may continue to see price declines if interest rates continue to rise. Note that the TLT ETF has a duration of approximately 16.35 years—roughly twice that of the current ten-year Treasury bond at 8.68 years. In contrast to the long-dated TLT, the iShares iBoxx High Yield Corporate Bond ETF, HYG, has a much shorter duration of only 3.98 years, as well as exposure to improving commercial credit markets, and may continue to outperform the long duration TLT ETF in a rising rate environment.
However, investors should note that the High Yield portfolio of HYG holds roughly 90% of its portfolio in bonds rated BBB3 through B3, with roughly 10% of its portfolio in CCC-rated credit (substantial risks). HYG top holding includes Sprint Corp (S) at 0.56% of the portfolio. The Vanguard Total Bond Market ETF (BND) maintains a duration of 5.5 years, though it holds 65.4% of its portfolio in government bonds and 21% of his holdings in AAA–A rated bonds. Compared to HYG and JNK, the BND ETF is slightly longer in duration (BND 5.5 years versus HYG 3.98 and JNK 4.20). But it’s very much concentrated in government and high-quality bonds, and will therefore be less impacted by changes in the overall commercial credit markets
Lastly, for investors looking to maintain yield while gaining exposure to the commercial credit market, an alternative to the iShares HYG, the Barclays High Yield Bond Fund ETF (JNK), offers a similar duration of 4.20 years versus HYG’s 3.98 years, holding 84.17% of its portfolio in corporate industrial, 7.65% in corporate utility, and 7.5% in corporate finance-oriented bonds. Like JNK, HYG is also a big fan of Sprint Corp. (S)(0.62%) and First Data Corp. (0.44%), and it also holds CIT Group (CIT)(0.26%), Caesars Entertainment (CZR)(0.24%), T-Mobile USA (TMUS)(0.24%), Tenet Healthcare (THC)(0.24%), Ally Financial (ALLY)(0.23%), and SLM Corporation (SLM)(0.22%).