By Vladimir Nikulin, CFA

During the last week, the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) price increased by 0.37%, primarily due to strong quarterly results of several US banks (JPMorgan (JPM) and Citigroup (C)) that not only reported better-than-expected results, but signaled that the U.S. economy might not be heading for a recession. Other asset classes also demonstrated positive returns last week: US investment grade bonds ETF (LQD) gained 0.44% and SPY gained 0.57%.

Figure 1. HYG ETF price dynamics during the week ending October 18

Source: Bloomberg Terminal

The US Treasury yield curve has almost no changes during the week. The US 10-year Treasury yield slightly rose (+2 bps) last week and ended the week at 1.75%. Short- term US Treasury yields slightly declined last week. Fed Vice Chairman Richard Clarida said the economy was still facing risks and that inflation was muted. But he did not comment on the outlook for interest rates at the upcoming Oct. 29-30 meeting.

The White House has announced that China agreed to buy up to $50 billion of U.S. farm products annually as part of the first phase of a trade deal, although China seems slow to follow through. U.S. officials said a second phase of negotiations could address thornier issues like forced technology transfer and non-financial services issues. Donald Trump said he thinks a trade deal between the United States and China will be signed by the time the Asia-Pacific Economic Cooperation meetings take place in Chile on Nov. 16 and 17.

There was a weak economic data from US and China. US retail sales fall by the most in seven months. US retail sales dipped 0.3 per cent in September, the biggest monthly decline since February. Some economists said that weak September US retail sales can be explained by a reaction to increased fears over US-China tensions. The recent weakness in spending, alongside the contraction in the manufacturing sector, pose a threat the longest US economic expansion on record. However, earnings from large banks this week, including JPMorgan Chase, Wells Fargo (WFC) and Citigroup, showed healthy quarterly results from retail operations. JPM posted strength across all but one of its segments, and executives offered optimistic comments about the financial health of individuals. Wells Fargo reported positive results in community banking, with growth in home, auto and card lending. Goldman Sachs Group’s (GS) fledgling consumer bank also saw strength in loans and deposits. As for Chinese economic data, its GDP grew 6% annually in 3Q, slightly below forecasts and the weakest rate since 1992. Trade tension with the US is the key factor weighing on business sentiment and investment activities, although domestic stimulus policies are providing some buffer from the downside. Moreover, the International Monetary Fund ((IMF)) once again lowered its projections for global growth this year from 3.5% to 3.0%.

Figure 2. Change in US Treasury Active Contracts Curve for the last week

Source: Bloomberg Terminal

The underlying HYG portfolio price increased by 31 bps last week, and NAV increased by 42 bps taking into account accrued coupon. HYG’s market price increased only by 37 bps due to negative premium change.

Figure 3. Contribution of sectors to changes in HYG over the week

Source: Bloomberg Terminal

Almost all the sectors demonstrated positive growth last week. The best-performing sector was Consumer, Non-Cyclical that added 0.8% last week. However, Energy was the only sector that ended the week taking negative returns (-0.26%).

The Consumer, Non-Cyclical sector added 0.8%, primarily due to bond prices growth of pharmaceutical companies, including Teva Pharmaceutical (TEVA), Mallinckrodt plc (MNK) and Endo International (ENDP). The companies’ bond prices climbed on hopes that the drugmakers and distributors were nearing a $50 billion settlement that would release some companies from lawsuits related to the U.S. opioid epidemic. The trial is scheduled to start on October 21.

The Energy sector lost 0.26% last week following lower oil prices and weak quarterly results of some energy companies.

Figure 4. HYG sectors’ weekly price changes

Source: Bloomberg Terminal

If we do not take into account economic data, the one trigger for HYG’s price growth would be related to weaker perspective of investment grade bonds. According to Bloomberg Intelligence, many BBB issuers have leverage profiles more consistent with their BB sector brethren. The trend in capital goods – 29% of issuers accounting for 50% of sector debt – overstates the exposure given many captive finance arms that inflate consolidated debt-to-EBITDA. Within the almost $2.9 trillion BBB tranche, almost 24% has a Bloomberg composite rating of BBB minus or lower. Drilling down further, $140 billion of that has at least one positive outlook, while $165 billion has at least one negative outlook.

Figure 5. BBB Leverage Profile by Sector

Source: Bloomberg Intelligence

Such a situation indicates that there is a risk that significant amount of BBB issuers could go to the “Junk bonds” category, as they have leverage ratios that are consistent with a BB rating. It would have negative consequences for price of US investment-grade ETFs such as LQD (BBB issuers represent almost 50% of total issuers by bond amount outstanding).

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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2019-10-22