SHYG: Wait Till The Beginning Of The Next Economic Cycle – iShares 0-5 Year High Yield Corporate Bond ETF (NYSEARCA:SHYG)

ETF Overview

iShares 0-5 Year High Yield Corporate Bond ETF (SHYG) focuses on corporate bonds that have ratings below investment grades. The ETF tracks the Markit iBoxx USD Liquid High Yield 0-5 Index. SHYG provides exposure to a broad range of U.S. high yield corporate bonds that will mature within 5 years. In addition, it provides a vehicle for investors seeking higher income in the fixed income market. However, these bonds have much higher credit risk than investment grades bonds. The fund is especially vulnerable in an economic recession as default rates can spike quickly in such environment. We think investors may want to wait till the beginning of the next economic cycle to invest.

Data by YCharts

Fund Analysis

High credit risk

SHYG’s portfolio of bonds are below investment grade bonds. These bonds tend to be riskier than investment grade bonds and are much more vulnerable in an economic recession. As can be seen from the chart below, high-yield bond default rate has spiked following the past two recessions in the United States (yellow solid line). In the last recession in 2019, the default rate went up to nearly 15%.

Source: Moody’s Capital Markets Research

SHYG may be in a better position than other similar high yield bond ETFs as 44.5% of its bonds in the portfolio are BB rated bonds. In fact, only about 11.7% of its bonds are CCC rated bonds. Nevertheless, CCC or lower rated bonds have much higher average default rates of 5.9% in the past 20 years than the 1.3% average default rate of BB rated bonds. On the other hand, investment grade bonds’ average default rate is only about 0.10% per year.

Source: iShares Website

Higher sector concentration

High-yield corporate bonds often do not have good liquidity. This means that management has to apply some portfolio screening rules to only hold bonds with better liquidity. The consequence of this approach is that it may result in much higher concentration in certain industry sectors. As the chart below shows, about 21% of SHYG’s bonds are concentrated in the communications sector. In addition, the company has a high concentration to cyclical sectors as consumer cyclical and energy sectors represent about 13.4% and 13.1% of SHYG’s total portfolio respectively.

Source: iShares Website

This higher concentration in cyclical sectors such as consumer cyclical and energy sectors may increase the risk of defaults in an economic recession. As the chart below shows, the energy sector has one of the highest default rates among all sectors.

Source: Moody’s Investors Service

Lower interest rate risk

SHYG only holds bonds that will mature within 5 years. Its average term to maturity is about 2.3 years. Therefore, its fund price is less sensitive to the swing of interest rates. This means that in a rising interest rate environment, the fund can perform slightly better than other funds in the same category.

Relatively higher management expense ratio

SHYG has a management expense ratio of 0.3%. This is low compared with its sibling iShares High Yield Corporate Bond ETF (HYG), which has a MER of 0.49%. SHYG’s MER of 0.3% is also better than SPDR Bloomberg Barclays Short Term High Yield Bond ETF’s (SJNK) 0.40%.

A 5.7%-yielding dividend

SHYG investors will receive dividends with a yield of about 5.7%. As the chart below shows, its yield is towards the high end of its 4-year yield range. SHYG’s yield is on a rising trend. Investors should keep in mind that corporate bonds are fixed income bonds. This means that investors should not expect dividend growth. Hence, the rising yield trend means that its fund price is on a declining trend in the medium to long-term (see chart below). Hence, we believe this may not be the best time to invest in SHYG.

Data by YCharts

Macroeconomic Analysis

The current economic cycle has been well into its 10^th year. Nevertheless, there are already many signs that we are already in the late cycle environment. For example, treasury yield (10-year minus 2-year) is now near the point of inversion (see chart below). As can be seen from the chart below, economic recessions often precede with yield inversions (when the 10-year yield minus 2-year yield falls below 0%).

Source: Federal Reserve Bank of St. Louis

Besides yield inversion, we are also seeing signs of investors rotating from riskier assets (e.g., energy, industrial, etc.) towards defensive sectors (e.g. telecom, utilities, REITs, etc.). This equity rotation is often a sign of a late cycle environment. We think investors should not simply seek for high yield such as investing in SHYG in a late cycle environment because SHYG is considered a risky asset. Its fund performance could turn negative quickly as the default rate spikes during an economic recession.

Invest in SHYG at the beginning of an economic cycle

We believe the best time to invest in SHYG is at the beginning of a new economic cycle. This is because high yield bonds will have a much higher yield at the beginning of the cycle. Since SHYG is a relatively new bonds (inception date was back in October 2013), we do not have any historical performance in the last recession. However, we know that its sibling, HYG’s yield was as high as 10% in the last recession. As the economy continues to improve, HYG’s fund price went up quickly. Therefore, we believe SHYG will follow similar trend in the next economic cycle.

Investor Takeaway

Based on our analysis, we believe now is not the time to invest in SHYG as we are already in the latter stage of the economic cycle. We think investors should take a more conservative approach especially knowing the fact that default rates of high-yield bonds will spike in an economic recession. Investors should wait till the beginning of the next economic cycle to invest.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This is not financial advice and that all financial investments carry risks. Investors are expected to seek financial advice from professionals before making any investment.