Launch the Dirigibles! (HYG, FB)

We want to spend a few minutes discussing high yield investments – and not just because we like their prospects.

High yield securities, or junk bonds (as many prefer to call them), are an outstanding barometer of market psychology. That is, they provide a very useful snapshot of where both main street and Wall Street stand vis-à-vis the overall state of our bull market at any given moment.

How do they do that?

It’s a dynamic indicator, to be sure. But by examining the current spread against Treasuries, default rates and the general sensitivity of this unique asset class to the stock market’s gyrations, we can get a fairly accurate read of where the investment world sits.

murry

Right.

To begin, let’s take a look at the Bank of America/Merrill Lynch U.S. High Yield Master II Index, which offers an ongoing measure of the spread of a representative group of high yield securities against a benchmark government Treasury.

A quick glance at the chart shows us that until recently the spread between the two was declining for over two years – save for a couple of minor retracements (green line).

boamy

But after bottoming in mid-June of this year at just 335 bps above treasuries, spreads have been widening, a development that’s normally associated with a perception of greater risk in owning junk bonds.

But that’s puzzling…

Because it doesn’t appear that this latest backup in yields has been the result of genuinely higher default rates. Perhaps a fear of higher default rates, or just a lingering worry that with the overall equity market in a funk, junk bonds pose a greater than acceptable risk to those who hold them, but default rates are, in fact, low.

We have our opinion on the matter, to be sure – and you’re damn well going to hear it. In just a moment.

Consider first the very matter of default rates.

Even as spreads pushed above 500 basis points just a week ago there was no change in high yield default rates, nor in the expectations of a greater number of them in the immediate future. Rather, the sell-off in junk appears to have occurred as a direct result of the equity market’s decline.

Current (2014) default rates are just 1.7% — far lower than the long-term average of 4% for the series, and would be much lower still had there not been a very high profile blow-up earlier in the year.

Look here –

lta

And while it’s possible that we may see another big default before year’s end from the entertainment sector (Caesar’s), chances are it’ll be a one-off episode, and the full year’s numbers will come in strong.

Positive on Junk

With interest rates as low as they’ve been, the number of refinancing’s in the junk sector have skyrocketed. In fact, refinancing has become almost a matter of necessity, as many issues become cheaper for corporations to service than their initial offerings.

Moreover, with absolutely nowhere for fixed income investors to turn in this extraordinarily low-rate environment, high yield currently offers a relatively low risk alternative for widows and orphans to park cash while Treasury rates begin their climb back toward historical norms. In other words, demand should remain robust.

And finally, as the chart below shows, high yield trades more off its underlying equity than it does interest rates. As to that latter relationship, there’s very little correspondence.

This is the iShares iBoxx High Yield Corporate Bond ETF (NYSE:HYG) for the last year –

hyg

And as you can see, the gyrations in the stock match the major market indexes almost 1:1.

Look now at the technicals.

To begin, we have a large swell in volume (red box), up to six million shares traded daily from just three million in mid-July. That’s selling that’s associated with a steep decline in shares, so it carries extra weight. Clearly, folks got scared. Likely because the stock market was falling they chose to bail out of all risk assets. And what could be more risky than high yield? The recent lows, therefore, mark a selling climax

Notice also that at the 52-week highs set back in late June, there was no volume climax. In fact, average daily trade was at its nadir for the year. This tells us that HYG – and by extension, the rest of the high yield bond sector – has just experienced a minor retracement low in an ongoing bull market, and proper action at this stage is to buy the sector in order to take advantage of the tremendous yields still on offer. HYG, incidentally, now pays a very comely 5.05% annually.

And one more thing – RSI and MACD indications are also urging us to buy. RSI climbed above its midway waterline just over a week ago and MACD looks ready to confirm by midweek. Once that happens we’ll have one more technical reason to initiate a long bet on junk.

Spend some cash, cheapskate!

 

But why wait? No one else is. Last week, investors returned to the high yield realm to the tune of more than $1.7 billion.

And this week, you can, too.

We say junk got smacked because an overly sensitive, Prozac-popping news-addicted investment community can’t see the big picture sufficiently well to wait out these minor storms.

Nor will they be wise enough to get back in early enough to capitalize on a tremendous buying opportunity.

Our recommendation is to buy the junk sector using CALLs on HYG and at the same time sell some premium to offset the cost.

It goes like this –

[mepr-rule id=”203″ ifallowed=”hide”][mepr-unauthorized-message][/mepr-rule]

[mepr-rule id=”203″ ifallowed=”show”]

Wall Street Elite recommends you consider the purchase of the HYG March 94 CALLs for $0.55 and sale of the HYG December 89 PUTs for the same price. Total cost for the trade is nil.

241

What, another trade? You guys are tops!

 

That’s right, Dwight. We’ve got one more for you to look at.

It’s an action on a trade we opened just last week in our letter called Climbing Behind the Virus. There, we urged you to ‘like’ a Facebook trade we recommended that employed – like this week’s HYG trade – both a long Call and a short PUT.

Today we’re recommending you close the CALLs and let the PUTs ride ‘til the end of the week when they’ll likely expire worthless.

FB stock is now at $80.67 and would have to drop more than 11% in order to put those options in-the-money.

Not likely.

Take the CALLs (which you bought for $4.00) off the table and check back with us next Monday to tabulate the winnings.

[mepr-rule id=”994″ ifallowed=”hide”][mepr-unauthorized-message][/mepr-rule]
[mepr-rule id=”203″ ifallowed=”show” description=”wall_street_elite_members_only”]

Wall Street Elite recommends you consider a) initiating the long HYG CALL/short HYG PUT as outlined above, and b) selling your FB March 85 CALLs. They’re now going for $5.30.[/mepr-rule]

[mepr-rule id=”988″ ifallowed=”show” description=”executive_lounge_members_only”]

Wall Street Elite recommends you consider a) initiating the long HYG CALL/short HYG PUT as outlined above, and b) selling your FB March 85 CALLs. They’re now going for $5.30.[/mepr-rule]

With kind regards,

Hugh L. O’Haynew, Senior Analyst, Normandy Research

Share your thoughts...

We encourage people to join in on the discussion. Please keep in mind however, that all comments are moderated according to our comment policy, and all links are nofollow. Let's keep the conversation professional and meaningful.