USHY: Credit Spreads Low Given Recession Risks

The iShares Broad USD High Yield Corporate Bond ETF (BATS:USHY) is a good way to observe some of the dynamics in our current macroeconomic backdrop. We think that it is clear across asset classes, except perhaps private markets, that markets believe recession concerns are overblown. We still think that the inflation was relatively transitory - or at least that the underlying price increases came from the supply side first - so we think that markets probably have it right. But given yield curve inversion and the powerful logic behind the yield curve in this case where rates are higher than we've been used to for a long time, markets may have it wrong. USHY has credit risk and is priced with credit spreads that we think could be too low for a recessionary scenario. There's no upside here in our opinion.

USHY Breakdown

The important data is that the effective duration is around 3.2 years. The YTM is 8.6%. Based on the yield curve, the implied credit spread here is 4.36%. USHY sector exposures are primarily consumer cyclicals, which are the most recession exposed issues - things like cruises and cars.

Based on data by Schroder's, current credit spreads for higher yield issues like those in USHY should be around 4.6%. So USHY, being skewed towards some riskier sectors, already has a lower than average credit score to answer for. But the issue goes on, which is that historical averages for credit spreads are much higher than they currently are in a recessionary market. Spreads are around 2016 levels for US high yield issues, or around 2019 levels, and neither of those markets were perilous, in fact both were low volatility and excessively bullish on the equity side. Usually in a recession spreads will widen meaningfully. Financial crisis aside, COVID-19 saw spreads almost hit 10%. The dot-com crash saw beyond 10%. While this recession may be more shallow, spreads around a non-recessionary average is a little optimistic.

Bottom Line

Supposing that USHY is priced optimistically on the basis of credit spreads, there is also the fact that while a 3.2 duration is not short, it's also not exceptionally long, so the offset if policy is revised downwards is not going to be as high. So while there is some downside protection on prevailing rates, it could be more. There's also the matter that credit spread concerns are still going to trump revisions to prevailing rates, especially since monetary authorities tend to overtighten and stay tightened too long due to the complexity of managing the economy with rates, which is not a direct economic impulse the same way fiscal policy is. USHY has low expense ratios at 0.15%, or 0.22% once the fee waiver expires in less than a year, but besides a relatively cheap maintenance cost, USHY and high yield investments are at risk of revision to economic forecasts. We still haven't seen things like automotive volumes come down, or other signs of a credit crunch on important parts of the economy yet. Things could still go wrong.

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