SPHY: Junk Bond Spreads Are Far Too Low Given Debt Maturity Wall

seekingalpha03-29

Bond market volatility has been unusually low, raising concerns about potential market shocks and skewed expectations.High-yield bonds, such as SPHY, have low yield spreads to Treasuries, meaning they...

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MediaProductionSince suffering record declines, the bond market has been eerily quiet since the latter half of 2023. Volatility in both Treasury and corporate bonds has been much lower than usual, even lower than before the 2022 bond market crash. Inflation expectation data has, for the most part, also been stable, likely due to stability in the energy market. As detailed regarding CME Group (CME), the first quarter of 2024 is likely one of the least volatile in recent history based on implied volatility data, regardless of the asset class. In short, markets are stable today. In my view, they are too stable. While many investors enjoy periods of low volatility, they can often skew expectations, causing challenging surprises when an external event inevitably creates a market shock. To me, the market is primed to face a black swan risk in that if one occurs, implied volatility levels (such as the VIX) are so low that there may not be sufficient bracing for such. Admittedly, with inflation moderated and the Fed potentially cutting interest rates by year-end, there are fundamental reasons the quiet market is justified. However, should that change, investors may not want to be caught in assets with asymmetric risk profiles. I believe one of the most asymmetrically skewed assets today are high-yield bonds, such as the \"junk bonds\" in the SPDR Portfolio High Yield Bond ETF (NYSEARCA:SPHY). SPHY is popular among some investors due to its higher yield of 7.5%. However, while that appears to be an excellent yield compared to the pre-2022 dynamic, it is pretty low when investors can earn over 5% risk-free. SPHY has risen since 2023 as the economic issues wrought by inflation fade. That said, from this year through 2028, companies will likely be repaying a substantial amount of debt due to a debt buildup since ~2010 that, with interest rates higher, cannot continue to be refinanced. With that in mind, I believe there is a reason investors may be best to avoid SPHY today. Indeed, SPHY may be a decent short opportunity, given low implied risk levels today. SPHY's Yield Spread to Treasuries Is Too Low I do not believe that \"junk bonds\" are, by themselves, bad investments. Indeed, I historically prefer high-yield bonds to Treasuries because they have less duration risk due to their superior yields. However, that benefit is significantly reduced today due to the sharp decline in corporate bond spreads to Treasuries. That can be seen clearly in the spread between SPHY's dividend and the risk-free rate. See below: Data by YChartsToday, SPHY only pays a yield 2% higher than the one-month Treasury rate. Theoretically, the one-month Treasury rate is risk-free because the US government can create money to pay its debt, and it lacks duration risk in case of rate changes. I continue to avoid bonds with high-duration risk, such as ultra-long-term Treasuries. However, SPHY does benefit from a low duration risk of ~3.2X, meaning a 1% rise in rates would lower its value by ~3.2% (and vice versa). That may be why low-grade corporate bonds are trading at a relative premium today, but I'd still prefer shorter-term, risk-free assets like (BIL) that have a 5.5% yield without risk. More importantly, yield spreads on junk corporate bonds are extremely low today. In fact, they are the lowest since the late 1990s, and that period did not end well for corporate bondholders (see Long-Term Capital Management Crisis). Corporate bond spreads are a measure of risk based on the difference in yields between Treasuries. When they are low, the market is not concerned about credit issues and will pay a premium for junk bonds. This measure is closely correlated to the VIX index. The weighted-average credit rating of its holdings is around BA3 to B1, which relates to the spreads below: Data by YChartsFundamentally, SPHY is a short volatility trade. Some of its price action, such as that of 2022, was driven by changes to Treasury rates. However, most of its price action will be inversely tied to the VIX index, which, although an equity risk measure, is strongly tied to risk premiums on junk bonds. Today, the VIX and corporate bond spreads are near record lows, implying the market perceives minimal credit risk in corporate bonds. This premium juxtaposes the expected pressure from the impending corporate debt maturity wall. Most corporate debt on the market today will mature from 2024 to 2028. This \"wall\" is vast for junk bonds, such as those in SPHY, with nearly a third of high-yield debt maturing within the next 36 months. Currently, this is about the most concentrated debt maturity wall since the buildup began around 2010. With spreads so low, companies are successfully refinancing some of that debt. Still, their ability to continue to refinance is limited because borrowing costs are much higher today than they have been. Most of this debt was continually refinanced from 2010 to 2020 at low rates, but now that rates are higher, a relatively significant increase in interest costs will come with refinancing. Extreme low spreads do heavily offset that burden, allowing for refinancing, but should that reverse, I expect it could scale into a crisis among the more indebted companies. In my view, investor views today are skewed mainly by the activity of the largest companies. It is true that the largest, healthiest firms in the US are performing very well and have seen profits soar since 2020 despite lackluster consumer strength. That said, market breadth has been very low, with only a slight but notable rebound in recent months. Still, since 2020, many companies have struggled, while the largest have benefited. Thus, I'd argue the risk of default among at-risk firms in SPHY is higher than usual. Betting on a Junk Bond Volatility Spike Overall, I am bearish on SPHY and believe it is a poor investment choice today because its spread to Treasuries is far too low compared to the fundamental risk in junk bonds. To me, the junk bond spread should be higher today to offset the economic issues straining many firms and the massive amount of near-term junk bond debt maturities. However, because investors are willing to invest in SPHY and other \"short volatility\" bets, they're essentially bailing out these firms, taking a low spread (paying a premium) for seemingly high-risk assets. By high-risk, I do not only mean because they are junk bonds but because they carry more risk than they normally would due to their ongoing refinancing race. For this reason, I believe SPHY is an excellent short opportunity today. That said, the best way to bet against junk bonds may be through put options on SPHY. The ETF currently has an extremely low implied volatility of around 10%, far below its average level of ~20%. That means long put options are relatively cheap as the market is pricing for a small risk of declines. To me, that is a decent way to bet against SPHY with defined risk and asymmetric upside potential. Notably, SPHY crashing risks are relatively low on any given month. I'd put a minimal amount in SPHY put options each month, using cash I expect to lose to hedge asymmetrically against my long positions. While I am bearish on SPHY, there are not necessarily immediate catalysts that could cause a crash, but there is reason to suspect catalysts should arise within the next twelve months. Thus, I expect SPHY to remain around its current price but crash at some point by 2025. SPHY options are very illiquid, so that is a way to bet against it, but only with minimal money. Most likely, that money will be lost (if rolling monthly as I prefer), but if SPHY does see a 10%+ drop, as I expect, it should result in highly outsized returns given its low IV levels.  Again, I see this bet not so much as a way to earn a considerable profit return but as a means to hedge against market risk without tying up too much capital in a short position. Put options by themselves will usually expire nearly worthless, particularly if out of the money, as I'd prefer), giving it high risk. However, with SPHY's position today and its implied volatility level, I believe the overall risk-reward profile of those options is very attractive, particularly as a means of hedging.","kind":null,"is_publish_news":null,"is_publish_highlight":null,"is_publish_live":null,"is_publish_wemedia":null,"editions":null,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.22.4","shortVersion":"4.22.4","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2423468801"}