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The Veteran's in charge today...
Tim and I often have a private chat between ourselves, a sort of brainstorming session over discord, in which I often lament the weather in the UK and dream of sunny Spain.
But as Tim recently pointed out he had just endured a couple of weeks of rain, reminding us that the grass isn't always greener.
And looking out of the window of my slightly ramshackle garden office (which a wag has christened “Goldman Shacks”) I note the lush looking grass of our own back lawn.
In one of our recent discord chats, Tim shared the chart below, in a sort of “light the blue touchpaper and retire” kind of way...
Naturally, I bit, countering with:
“Have to be very careful when treating these things in aggregate there are likely to be a large number of HYG bond borrowers who are stretched going forward for example”
Because, as many investors have discovered to their chagrin, when something looks cheap, it's often cheap for a reason.
Now I am no fixed income expert but I can see and draw parallels, to and with, the world of equities here.
When a stocks' dividend yield moves out of kilter with its immediate peers and the wider market it means one of two things. It’s either become a value play or that dividend is unsustainable and likely to be cut or discontinued going forward.
High yield bonds are high yield precisely because the market demands a bigger return to lend money to the bond issuer/borrower. It's the classic example of a higher risk being associated with a higher reward.
However, that higher reward comes with a Big IF attached. Which is: IF the bond issuer pays the coupon and/or the principal.
Looking for a proxy for the high yield bond sector I settled on HYG, the iShares Iboxx High Yield Bond Index ETF (well, you would wouldn't you) and I started digging.
The chart below is a sector overview of HYG’s bond holdings. There are more than 1000 in the fund overall I believe, so from that standpoint, it's well-diversified, though those holdings are held in a wide range of weights.
And it was weightings within the ETF that took my eye. My comments to Tim follow:
“20.0% of the fund is in the bonds of consumer discretionary stocks (and) another 11.79 in energy, so there is plenty of cyclicality in there”
Is that a bad thing?
Well, not in its own right and certainly not during an economic boom.
However, we are not in an economic boom, are we? Or if we are, it's in its last hurrah (?).
Prices are rising and household disposable incomes are likely to get squeezed further from here.
Something in the below chart will have to give, and in the near term, it probably won't be the rate of inflation.
Let’s remind ourselves that PCE or Personal Consumption and Expenditure (the consumer) is 70% of US GDP.
Every time I read that figure it astounds me, but there it is.
The chart above breaks down US consumer spending by category and income cohort.
As we can see housing makes up a large chunk of US consumer spending, in aggregate it accounts for 34.90%.
So, just imagine how discretionary spending might get squeezed if the cost of housing was rising, and then look at the charts below.
Disposable income and Mortgage rates in the USA 👇
Some context on the size of mortgages and house prices in the USA.
I have chosen to focus on mortgages and the outright cost of housing rather than rentals, although the trend is similar in both. 👇
Overall then it looks like it's gonna get messy. Q1 earnings and outlooks (especially) may show how us just how messy.
S&P 500 Consumer Discretionary stocks that are reporting earnings in April 22.
Now of course having advanced this argument I need to recognise that 11.0% of HYG is in the bonds of Energy stocks whose earnings and cash flow are through the roof at the moment.
However, for all that, they are no less cyclical than the consumer discretionary names mentioned above.
In fact, this chart just exemplifies the swing from peak to trough and back again in these kinds of sectors. 👇
All of the above is interesting and I believe relevant. But it's not sufficient to determine whether or not an investment in High Yield Bonds or the HYG ETF is justified now.
Of course, we could decide to ferret out the credit ratings for each of the issuers of the bonds that are held in HYG, or which make up the High Yield sector, but that’s not so easily done and is likely to be very time-consuming.
One way to fast track that would be to look for data on average default rates within the high yield bond sector and one place to look for that data would be the ratings agencies.
They keep this data tightly locked away unless you are paying for it.
However what we can say is that the default rate for corporate bonds during 2021 was at a record low of just 0.50% of issuance, according to Fitch data. The expectation is that this should move up to just 1.0% and then 1.50% across 2022 and 2023.
However, there is a caveat here and it’s that those forecasts are non-recessionary.
If there is a recession then the figure to be aware of is the recession average default rate of 2.50%.
Without a recession, Fitch envisages defaults on around $15.0 billion of bonds in 2022. However, the ratings agency points out that this is just a fraction of what was seen in the last recession in 2020, when $68.50 billion of defaults were registered.
Net-net then beauty is in the eye of the beholder and their view of the probabilities and timing of the next recession.
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