Avoid USHY ETF Due To Weak LevFin Conditions And Duration Risk

The iShares Broad USD High Yield Corporate Bond ETF (BATS:USHY) is a way to play higher yield, more junky bonds in the world of corporate debt. This ETF in particular has some duration risks, and the whole category of leveraged finance is in a bit of a shutdown right now, so the financing conditions for the underlying companies have deteriorated. For the YTM, the benefits seem a bit limited relative to liquidity in the markets for high yield debt and for the duration risk involved in the portfolio. We think it’s a pass.

Breakdown of USHY

Let’s have a quick recap of the key figures relating to the debt within USHY. The duration is on average about 4.3 years across the portfolio. The YTM is consistent with the higher yields in the portfolio at 9%, and the coupon rate is about 5.7%, so they are trading below par unsurprisingly given the recent evolutions in interest rates.

A 4.3 year duration implies sensitivity to interest rate changes by a factor of 4.3x, meaning declines can be steep as rates rise. There is convexity in bonds, because as the discount rates rise, durations do shorten, hence future declines are increasingly limited. Nonetheless, a 4.3x factor is meaningful at this point and duration risks are high.

Remarks

Let’s begin with the YTM of 9%. That is currently at about a 4.9% premium to the 5y Treasury rate. This is consistent with a long-term average premium for Caa bonds, which are the best among C rated bonds but still very much junk bonds. The thing is that current leveraged finance markets are essentially closed, and that’s why PE has totally slowed down, and stopped entirely in the buyout and megadeal space. There are some signs of initial recovery, but credit in general in the high yield space is very illiquid right now, and refinancing conditions are substantially reduced, to the point of being non-existent in the cases of some companies. Long-term premiums are maybe not applicable right now, something steeper may be needed.

At any rate, whether the premium is too small or not, the credit risks are quite substantial, and the economy is absolutely not on the best footing. Jobs report is pointing to more inflation and the need for higher rates, and mortgage rates are now going above 7%, which is very steep. Eventually something will have to give, as the fed is looking to create some degree of economic hurt to decrease inflation. How serious those declines will be given the strength of the job market till now is unsure, but when layoffs start and spending declines rapidly as people’s loans remain, we could get an unemployment spiral which puts corporate credit at risk.

Regarding duration risk, in a similar vein, the jobs report is pointing to higher rates which will have a direct effect on the value of bonds beyond reassessment of credit risks. These rates may persist, so the diseconomy created on relatively low coupons from a lower rate environment may not see any retreat. Indeed, the Fed apparently is entirely prepared to let rates stay high if that’s what is needed before inflation finally falls. With substantial duration risks in USHY, this is bad news.

Overall, we don’t think investors should be rushing into long duration portfolios, and especially into assets that have a pretty limited market right now. Best to pass.

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