Got Junk? Examining a potential opportunity in high yield bonds

September 1, 2023No Comments

Hello and welcome once again to the Smart Money Dumb Money Show. And I am your host, as usual, Keith Richards. I’m President and Chief Portfolio Manager of ValueTrend Wealth Management. And today we’re going to talk about  high-yield bonds. High-yield bonds have other names sometimes assigned to them. The original term for old dogs like me is ‘junk bonds’. I’ve been in the business since 1990 and back in the day that’s what we called them. Now they’re called non-investment grade or high-yield and sometimes distressed debt, although that’s not always an accurate description of what non-investment grade bonds are because they’re not always distressed, they’re often just rated lower than what can be called investment grade. And when we talk about investment grade companies like pension plans and that, or certain institutions, perhaps your local church, they will have some sort of a written policy that says if you’re going to invest the money for our school or church or whatever it is you’re looking at, you can’t buy anything less than an investment grade bond.

So just because the bond, for example, is rated double B rather than A, which is an investment-grade bond, doesn’t mean the double B bond is on the brink of extinction. It just means it could be someday, but at this moment just not as good a quality as an A-rated bond. Okay, so just to clarify, when we are looking at lower-grade or non-investment grade bonds, we’re really talking about a wide swath of bonds. That could be anything from outright distressed companies issuing them to not-so-bad companies that just happen to have a lower credit rating. So we’re going to look at the single most popular ETF. In fact, it was the first ETF created to follow and invest in non-investment grade bonds, and that’s JNK on the US.

Now obviously this is going to focus largely on the US market bonds, although they do hold international holdings, but it’s a really, really good benchmark for that sector if you want to call it that. Now, within any type of corporate bond ETF, you can’t really call it a sector because they’re invested in all kinds of stuff. They’re in materials, they’re in airlines and banks, and you name it all the different sectors that you can imagine within stocks. Well, they’re all within one ETF and they classify it as in this case, distress debt or junk bond or non-investment grade bond, Call it what you will ETF, but it’s got a lot of different moving parts within that. But what we’re looking at is the credit ratings. And so what we’re following when we’re buying a JNK type ETF is we’re following what the spreads are doing because they were widening and narrowing according to the outlook for the economy really because obviously, companies with lower credit ratings are going to suffer a lot more than companies with higher credit ratings. That kind of makes sense, doesn’t it? So they’re really also an indicator of risk-on versus risk-off because you’re not going to buy a bond with distressed debt or distressed ratings I should say, or even a double B rating if you think the economy’s going down and the companies in general in what makes up the economy are going to suffer, you don’t want to buy a company that could be subject to some real problems and possibly even bankruptcy if the economy gets really bad.

So it’s a risk-on, risk-off indicator because when everybody’s excited about the economy and has very bullish anticipations of what’s going on out there, then you can actually do very well in distressed debt. And I keep saying distressed debt and what I really mean is non-investment grade bonds. So you have to keep in mind that this is more of a reading of risk-on/risk-off than it is on anything else. So let’s take a look at the chart because that’s what this program’s all about. And I’m just going to pull up a chart of the JNK ETF. As I said, it’s been around an awful long time and what you can see here is your classic basing action where you’ve got this extremely defined ceiling. Now, anybody that disputes technical analysis and then sees a point of resistance like this at about $92 and it’s so precise, I mean look at that, even the spike off of the close hit exactly that 92 point over and over like precisely. And here we are again right at that same level pretty much precisely. So I don’t think there are many naysayers left in the dispute over whether technical analysis makes sense, but I think this chart really does illustrate a perfect-looking neckline. So you guys know by following my work that you need to see a breakout from a neckline. That hasn’t happened yet. And when I look at the technical

Indicators here, you’ll notice that there’s really not a lot of signs that you’re going to get a breakout just yet. Alright, so this is RSI. It’s kind of flat. This is stochastics. Yeah, it’s a little overbought it’s not super overbought, it’s not super oversold, it’s kind of flat. MACD, which is a long-term indicator, you can see the histogram is the secret here. You can see it’s going nowhere. Alright? You can see it’s flattening out. It’s still rising. So it’s a reasonably bullish look, but it’s not exciting. So I’m going to give this chart a 5 out of 10. There’s nothing bearish about this chart at all, and a breakout through 92 would be extremely bullish. It would probably bring you right up into the near a hundred dollars area, but that hasn’t happened yet. So just keep in mind that this is so far, not a chart that tells me that we should be buying.

But the question I have is, will it be a chart that we should be buying? Well, I quickly wanted to show you, by the way, before I get into some of the other charts, I want to go to the fact sheet put out by the State Street. So they’re called spider ETFs, and this is JNK as you know. And this is kind of a breakdown of the sectors. So you can see it’s got a lot of consumer-type stocks. So consumer, cyclicals, that’s things that you know, consumers rotate in and out of, like travel can be something that you do more at certain times of year than others. It’s got consumer non-cyclical. That could be a company like Kraft, although Kraft is not a low-debt or a low-credit rating company, but non-cyclical is like a staple. And then there’s communications companies and energy companies.

So these are the big guys in this group. You’re seeing kind of the consumer stuff, the communication stuff, and the energy. Those are the sectors that are most represented. But what I want to do now is kind of bring you over to, okay, so knowing those are the sectors, how much exposure to any one stock are we looking at within this particular ETF? And by the way, most of these high-yield bond type ETFs, well you’ll notice that they’re all, and these are rated in highest to lowest percentage of this particular bond in their portfolio. And you’ll see the highest bond, which is TransDigim, I guess it’s called, points half a percent. Alright? That’s the biggest exposure of them all. Compare that to the S&P. Take a look at how much exposure Google has in the S&P and tell me if this is a more diversified portfolio.

In fact, as you go down the list, you will find lower and lower exposure to each bond. So it’s a really good representation of these lower-quality bonds. And if someone buys one, you’re not really going to be stuck with, oh my gosh, what if Carnival Cruise, which is right here, goes belly up? They’re not likely to, I think they’re AA if I’m not mistaken, but whatever the case, it’s only 0.36 of a percent. So they could just outright fault. And that’s literally sometimes when you go down the line in the debt ratings with these companies, you would find that some companies do go bankrupt within these types of ETFs. They have so many of them, so many bonds, I should say. But it really almost doesn’t matter because they’ll have an extremely low representation of the extremely distressed debt that could in fact go bankrupt.

So it’s a diversified portfolio. I guess that’s the message I’m trying to impart. So if this breaks out, it is representative of what is the market thinking about lower-quality bonds, and I think even more important, it’s telling you what is the market thinking about risk-on versus risk-off. Clearly, these bonds are bought by risk-on type investors. That’s probably a given. So we want to see if this can break out. So that’s the point of my video here. I was rambling on there for a bit, but what’s the proof? What could happen? Well, let’s just take a quick look at the comparative between high-quality bonds in the US. This is a US ETF versus the JNK, the more lower-quality bonds. And you can see the JNK is the red line and it’s actually been trending up higher highs, higher lows.

It hasn’t put in a higher high recently, but the most recent low is a little bit higher than the last. And, you know, like we just saw in the last chart it’s kind of making a base and on the verge of trying to break out, you can see that they were following each other for quite some time, but of course now they’re not. And you can see that the TLT, the 20-year government bond fell like a brick, and yet the junk bond ETF did not. In fact, it’s kind of building up. But you can see of late the TLT has suffered and the JNK in fact has risen along with the stock market. And in fact, I would even be so bold to say that it is currently outperforming the S&P 500. Let’s see if I’m right.

Well, this is the S&P 500. This time the S&P is in red, and the JNK ETF is in black. And you’ll notice that of late, the pullback on the S&P is slightly larger than that of JNK. Okay? But I want to just point out a couple of things on this chart that might give us clues as to whether JNK will break that lid that we were looking at in the first chart. And so a couple things. First of all, normally there’s a fairly high correlation, so this is a correlation chart. The higher this line is, the more closely the two S&P 500 and the JNK ETF are moving together. So when you get a situation like this, they weren’t as highly correlated. In fact, you could see that the S&P was going sideways and JNK was going up here.

So if this line is low, it means the correlation doesn’t have anything to do with performance. It has everything to do with the correlation. And you can see that there are times when they don’t move together, but most of the time they’re kind of in sync about a 0.83. In other words, they’re about 80% of the time or 80% related in their movement. This is what I want to point out right here is that on occasion you’ll get massive differentials between the two. So when the spread, the difference here is about 5% or higher. It tends to narrow. So here was like a big one back in 2020, and the junk bond ETF was ahead of the S&P so to speak, at least on this price chart by 7%. Well, they came together pretty quick and you can see the differential narrowed after that, and got to about 6% here and it narrowed, and then it got to about 5 1/2% here, and it most definitely narrowed.

Okay, you can see how close the relationship was here. They were really tracking each other quite well with the exception of that one period early-22. And here you can see pretty close. I mean, what we’re looking at is the spread differential and we’re back to about a 5% spread. So the question is, will that spread get narrower as it did there and as it did there, as it did here, will the spread narrow and how that would work would be either the S&P 500 will underperform for a while, which would mean this red line would come down and underperform on a relative basis in price versus JNK or JNK would outperform on a relative basis versus the S&P. Who’s to say, I’m not going to make any predictions here, but the point is that for good old- fashioned ordinary technical analysis, when we looked at that base, what it needs is a catalyst, and perhaps it’s the spread,

The performance spread that is, differential between the S&P and JNK might change, and that could, ‘could’ possibly result in a breakout by JNK. If the market after say the correction that I’ve been suggesting would happen into September finishes, the stock market finishes its correction, and the market returns to a very strong risk-on attitude after the fall, then you could see junk by itself JNK by itself move out of that consolidation. It’s been doing okay considering what the stock market’s been doing. It seems to be holding its own. So I’m just curious to see if that’s going to break out because if it does, that would be a pretty darn good chart formation to trade off of. I will not predict, but I will prepare. As I like to say, it’s actually a Howard Marks saying that I’ve adopted, and so I’m preparing for that possibility by keeping an eye on JNK. Perhaps you should too. Thanks for watching. See you next week.


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