HYG: A Buy Case Amid Banking Crisis

This article explores the economic outlook and its implications for iShares iBoxx $ High Yield Corporate Bond ETF (NYSEARCA:HYG) in light of the recent collapse of Silicon Valley Bank (OTC:SIVBQ), which has triggered a regional banking crisis and affected various financial markets. The HYG market is particularly vulnerable due to the drastic decline in lending activities and increasing default risks. Despite the challenges, strong job growth, a slowdown in inflation, and potential interest rate adjustments may provide opportunities for investors. This article will examine the risk factors, historical responses of HYG to economic downturns, and technical evaluation to provide a comprehensive understanding of the current state of the HYG market. HYG has been observed to be consolidating within a symmetrical triangle, and a burst above the $76 threshold could present attractive investment opportunities for investors.

Economic Outlook

The recent collapse of the SIVBQ has sent shockwaves through the financial world, resulting in a massive run of depositors and triggering a regional banking crisis. The bank’s failure has left investors and depositors scrambling to withdraw their funds, thereby putting immense pressure on other regional banks. The HYG market crisis is just one of the various consequences of investors seeking safety by abandoning riskier assets, leading to a sharp decline in bond prices and a surge in yields.

The SIVBQ’s collapse has considerably worsened the effects on the HYG market due to the significant decrease in commercial bank balance sheets’ loans and leases, which have shrunk by more than $100 billion in a mere two weeks, as seen in the chart below. The sharp decline in lending activity has resulted in a severe credit crunch, impacting businesses of all scales, particularly those that depend on high-yield debt for financing. Consequently, the HYG market has encountered a surge in default risk, and investors have grown increasingly cautious of the deteriorating credit quality of these bonds. This elevated sense of uncertainty has led to a surge in bond market volatility. In my opinion, the reduction in loans and leases may prompt banks to reassess their lending practices, leading to a more prudent and sustainable credit environment in the long run. Additionally, the sell-off of high-yield bonds may present attractive investment prospects for astute, risk-tolerant investors.

On the other hand, the strong job growth in March 2023, with an increase of 236,000 seasonally adjusted jobs, leads to better consumer confidence and a boost to the economy. This rise in economic activity directly helps high-yield bond issuers, as companies are likely to see more revenue, which improves their ability to pay debts and lowers the risk of default. Additionally, solid job growth positively affects the credit quality of high-yield bond issuers. A thriving economy usually improves businesses’ financial positions, allowing them to reinforce their balance sheets and increase their creditworthiness. As a result, investors in the HYG market gain more confidence in issuers’ ability to fulfill their debt obligations, leading to more investment in the high-yield bond market.

Moreover, inflation has remained stable at 4.6% since December of the previous year, indicating a slowdown in inflation and suggesting that inflationary pressure is not increasing in the economy. This situation could influence the Fed to decrease the interest rates in the future, which may benefit the HYG market. A decline in interest rates enhances HYG prices, as it mitigates borrowing expenses for high-yield bond issuers, thereby rendering debt more appealing to investors and subsequently stimulating demand for bonds. The following chart depicts that the Federal Reserve (Fed) has elevated interest rates above 4.5%, yet inflation persists at approximately 4.6%; nevertheless, the current deceleration in inflation may influence the Fed to moderate the pace of interest rate adjustments.

Risk Factors

The outflows of Treasuries and mortgage-backed securities at a rate of $61 billion in March indicate a reduction in the Fed’s holdings and suggest a continued tapering of asset purchases, which might impact the high-yield market. Consequently, the HYG might face increased volatility and potential yield fluctuations as investors reassess their risk profiles and adjust their positions. Furthermore, these outflows might influence the credit spread between high-yield bonds and U.S. Treasuries, as the market recalibrates its perception of risk in response to the changing economic landscape.

On the other hand, the negative yield curve as seen in the chart below signals the impending economic recession, which can increase the credit risk of high-yield bonds, as companies may be more likely to default on their debt during a downturn. Therefore, the negative yield curve has a negative impact on the price of the HYG ETF. Nonetheless, the current negative yield curve is notably pronounced, indicating that a recession may be imminent. During a recession, the curve typically begins to rise, which can be viewed as a favorable development for the HYG.

Historical Responses of HYG to Economic Downturns

The fundamentals discussed above reinforce the technical outlook for HYG, as demonstrated in the accompanying HYG chart. It is evident that the price is trading within a robust bullish trend, creating a congestion zone by consolidating in narrow ranges between the $68 and $76 region. Historically, such consolidations have been associated with future market gains, as indicated by the chart below.

It is noteworthy that during the great recession, the HYG price fell by 35.91% from its November 2007 high of $40.49 to its November 2008 low of $25.95, before rebounding significantly. The great recession lasted one year and six months, with the price beginning to climb before the recession’s conclusion. The second recession, the Covid-19 recession, spanned only two months, but the HYG price declined by 23.36% within that timeframe before recovering. Based on this data, the potential recession in 2023 could affect investor confidence in HYG.

The chart below illustrates the weekly outlook for the HYG market, highlighting fluctuations within confined ranges and the formation of a symmetrical triangle. The boundary line of this symmetrical triangle is at $76, and a push above this level would confirm a bottom in HYG and suggest higher prices. The price movements within the symmetrical triangle imply that an upward breakout is probable. Additionally, the deceleration in inflation and a robust labor market lend support to the breakout.

Bottom Line

In light of the above discussion, it is evident that the labor market is exhibiting strength and inflation is decelerating, which may prompt the Fed to consider a favorable reduction in interest rates. This potential decrease in interest rates could stimulate demand for HYG. Conversely, the reduction in the Fed’s holdings, as indicated by outflows of Treasuries and mortgage-backed securities, and the negative yield curve have heightened market uncertainty, possibly leading to significant volatility in HYG. Nevertheless, the formation of a symmetrical triangle suggests that a breakout above $76 could present a promising entry point for investors. Investors may consider purchasing HYG during price dips amid a recession or upon a breakout above $76.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.