JNK ETF: The Income Finally Reflects The Risk (NYSEARCA:JNK)

Main Thesis / Background

The purpose of this article is to evaluate the SPDR Bloomberg Barclays High Yield Bond ETF (NYSEARCA:JNK) as an investment option at its current market price. This is a high-yield bond fund with a primary objective “to provide investment results that, before fees and expenses, correspond generally to the price and yield performance of the Bloomberg Barclays High Yield Very Liquid Index”.

I have suggested investors avoid this particular fund for a while, as I saw too much interest rate risk over the past twelve months. This outlook continued when I last reviewed JNK in November. In hindsight, this was an appropriate call, although perhaps I should have been even more bearish. That said, it is interesting that bonds have not provided any semblance of a hedge while equities have fallen too:

Of course, quite a bit has changed since last November, so I wanted to take the start of Q2 as an opportunity to revisit the junk debt market. After review, I finally see a buy case emerging where one was void for most of the last twelve months. Duration risk remains elevated with rising inflation and a hawkish Fed, but that reality has been the reason for the sharp decline in bond prices already. I see the potential for more downside to be sure, but believe it is limited in the short term. This makes the current yield more attractive now than it has in the past, and I will discuss why in more detail below.

Investors Can Finally Find Income – If They Take On Credit Risk

To begin, I want to take stock of the broader market and how this has impacted the fixed-income world. As readers are surely aware, bonds and credit have had a pretty poor start to 2022. This has included all sectors and themes – whether high yield, municipal bonds, treasuries, or IG corporates. The simple fact is that inflation has not been transitory, the Fed is finally starting to act, and real yields are negative across much of the quality bond market. This has made fixed-income investing very challenging (and likely unprofitable) for many market participants.

The good news is that the pain we have seen recently has created an opportunity. Is there more risk on the horizon? Of course, because the primary headwinds I highlighted in the prior paragraph (inflation, Fed action) remain in place. Yet, the good news is that those buying in now are finally getting compensated for these risks. What I mean is, current yields have risen sharply as prices have fallen. This offers investors income levels we haven’t seen in a while across most asset categories:

Of note, it is interesting that high-yield corporates are the highest yielding category currently. This is why I have chosen JNK as an option to highlight a reasonable way to play this macro-trend. There is more credit risk here to be fair, but this seems to be a reasonable risk-reward proposition. For investors deciding how to play the current environment, high-yield corporates seem to be the right move if yield is the primary focus.

Importantly, there is less credit risk further down the income ladder. Sectors like treasuries, IG corporates, or even an aggregate bond fund (which combines multiple sectors) are “safer” in terms of potential defaults. But these yields are simply not high enough yet to really pique my interest. With inflation rising and central banks taking action, “real” yields on these products are often still negative in this environment. This means that while defaults are not the headwind, interest rate risk is. For me, I want to take on that credit risk to have the potential for a positive real yield.

Defaults Have Been Minimal

Expanding on the above point, another attribute to support a bullish case here is actual default rates in the high yield space. As I noted, I believe taking on credit risk, rather than interest rate risk, is the right play in this market. But while the income offered could deliver a positive real yield, this forecast goes out the window if defaults are high and credit losses pile up. This is what keeps many investors in the investment-grade realm – they don’t want to take on default risk.

Let me say I do not fault anyone for this strategy, and this is a trend I follow myself when I look into the municipal market through my leveraged CEFs in that space. But for corporates, the spread between IG and high-yield income is often quite large. With a fair amount of spread to capture by taking on some risk, there is often merit to doing so.

I would manage expectations here by saying I would never encourage someone to take on more risk than they feel comfortable doing. If IG debt is what one prefers, I would not fault them for staying in that realm. Do I see value in the high-yield market now? Yes, I do. But there is inherent risk in moving into that sector, and investors should remain in their comfort zone. That said, a reason I feel confident in high yield right now, and JNK by extension is that defaults have remained very low. After a strong 2021, defaults have ticked up slightly so far in 2022, but the overall default rate remains well below 1%:

My point here is that high yield does not seem to be flashing any real warning signs right now. Despite some macro challenges across the globe, corporates are making good on their debt obligations. This backdrop supports taking on some credit risk here, as defaults are very manageable.

Energy Holdings Getting A Boost From Crude

I will now dig in a little deeper into JNK’s actual holdings. Positively, this is a fairly well-diversified high-yield fund, with exposure across a number of different sectors. In particular, focus right now is the Energy sector, which makes up roughly 12% of total fund assets:

I am highlighting this particular exposure because it has been a key driver of performance in the past few months. While some of the geopolitical risks we have seen have been a net negative for markets, whether bonds or equities, the Energy sector has actually been benefiting from some of the uncertainties.

The reason behind Energy revenues and profits tend to rise along with the price of crude. As Russia invaded Ukraine, crude prices soared. While they have moderated in the last few weeks, prices are still elevated, and that is helping the Energy sector’s equity prices and bond prices. In fact, the underlying debt in the Energy sector has sharply outperformed the broader high-yield corporate index over the past two months:

The thought here is the inclusion of these assets is a positive and could help drive returns in Q2.

What About Inflation? It’s A Risk, No Denying It

Through this review, I have presented a fairly optimistic picture. I stand by this outlook, and I do think a buy case is warranted now. But I must emphasize this is not a risk-off approach. This is always true of the high-yield market in my view, regardless of economic conditions. But in this environment, it is especially true. This is because inflation is real, accelerating, and will continue to pose a major challenge to fixed-income products in the months ahead.

The key here is to manage this risk because avoiding it entirely is not possible. If one goes up in credit quality, duration is higher. If one moves to stocks, inflation poses a challenge if it eats away at corporate profits. If one moves to cash, inflation makes those dollars worthless over time. In short, there is no magic solution for handling inflation, except buying and owning the products and assets that other people need and are willing and able to pay more for as time goes on.

This brings me to JNK. At a current yield nearing 6%, I think this helps to offset the potential declines from stubborn inflation metrics. In truth, the fund’s duration (interest rate sensitivity measures) is now “low”, but it is relatively lower than many IG products, coming in just under 4 years:

The conclusion I draw here is not that JNK is a way to avoid the risks of inflation and further central bank tightening. I don’t see how one can avoid that risk completely. But it does offer a more managed approach on doing so. The yield is higher, duration is lower (compared to IG funds), and this helps to offset any forthcoming pain on this front.

This is a critical point because, as I mentioned, inflation is not subsiding. We can look at a number of areas for this reality – whether it is CPI metrics, energy prices, or the cost for food. In fact, global food prices have hit levels well above where they sat in recent years:

This is just one index, but it reflects the wider trend. As long as prices remain elevated, inflation and the case for rate-hiking will be headline news. This is a very real risk readers need to factor in when deciding what funds to buy, whether it is JNK or anything else.

Bottom line

I have been viewed JNK pessimistically for a long time, and that view has finally started to reverse. The fund’s current yield looks attractive, even if central banks continue on a tightening path – as long as it is reasonable. For me, there is not enough upside in IG corporates, given the lower yield and higher levels of interest rate sensitivity. This makes me consider JNK as a better relative play. As long as defaults remain minimal and central banks don’t get too aggressive, I see a positive path forward for JNK. As a result, I believe an upgrade to “buy” is well warranted, and I would suggest readers give this fund some consideration at this time.