From the desk of Tom Bruni @BruniCharting
This week I’ve seen a chart of High Yield relative to Investment Grade Bonds floating around with various conclusions, but I wanted to use this to highlight some things to consider when using Bond ETFs as a proxy for what’s happening in the market it’s meant to track.
The chart in question today is HYG/LQD, which on the surface looks like it measures the relative performance of High Yield Bonds relative to Investment Grade Bonds. Based on the ETF names that seems like an innocent conclusion to draw and that this chart can be used to measure the risk appetite of bond market participants.
If they’re in a “risk-on” mode then they’ll be buying High Yield and driving the ratio higher, but if they’re “risk-off” then they’ll be buying Investment Grade Bonds and driving it lower. Given the ratio is back towards its 2009 and 2016 lows, this must be an ominous sign for risk appetite and the broader market in general…right?
Click on chart to enlarge view.
Well, kind of. The problem with this chart is that the two vehicles chosen have very different effective maturities. HYG holds bonds with an effective maturity of 4.26 compared to LQD with an effective maturity of 12.74. So while they are comparing the performance of High Yield relative to Investment Grade Bonds, it’s not an apples to apples comparison and the recent underperformance has been exacerbated by the rally in the long end of the curve.
With that said, prices are certainly extended to the downside and should find some support at current levels, which would suggest some near-term relief for lower credit quality bonds and the shorter end of the curve.
Another way of looking at this ratio is by using the ratio of JNK/VCIT, which has effective maturities of 5.93 and 7.50. A little closer, but again the recent decline has been exacerbated slightly by the longer duration belonging to the higher quality credit. Even so, this ratio is still in a downtrend, but not quite at its 2016 lows like the first chart.
Here’s the last ratio we’re going to look at, HYG/VCSH, which has an effective duration of 4.26 and 3.00 respectively. While still in a downtrend, this ratio is nowhere near its 2016 or 2018 lows and has yet to even break through its May lows. Again, it’s signaling to risk aversion and widening credit spreads, but not nearly to the extent that the other ratios that did not match duration as closely.
Another thing to consider in addition to duration is liquidity. During volatile market environments, market participants who cannot sell their illiquid securities will hedge their portfolio by shorting the ETF which holds similar securities. The same can be said on the upside. This can exacerbate price moves beyond the NAV of the fund and can lead to the ETF’s price action telling a different story than what the underlying market it tracks is telling.
These are errors I’ve made in the past and now know to stay on top of.
To track the credit quality, effective maturity, and premium/discount to Net Asset Value of the ETFs I follow, I use Morningstar’s free portfolio tool.
And for checking what’s happening in the underlying securities I look at the indexes themselves using tools like Koyfin, where I can look at the Total Return, Option-Adjusted Spreads, etc. of various credit indices.
The Bottom Line: Bond ETFs can be a great tool for market participants to understand what’s happening in the credit markets, however, the wrong signals/messages can be received if they’re not compared on an apples to apples basis. Three things to keep in mind are effective maturity, credit rating, and liquidity (premium/discount to NAV) when looking at Bond ETFs as a proxy for what’s happening in the Bond market.
While it requires a bit more work and is still far from a perfect solution, it’s important for us to adjust our analysis for these factors so that we have as close of a proxy to whatever we’re looking to measure as possible.
Thanks for reading and let us know if you have any questions!