During the early 2016 market sell off, few expected the sharp rebound that occurred shortly after, with high yield bonds rising close to 15%. With the election of Donald Trump heralding higher yields and lower crude prices, a lack of clear policy blueprints from both DJT and OPEC are leading to a junk bond sell off.

Junk Bonds, Crude and US 10 year

Crude Oil Impact

Oil production has continued to be resilient with the latest EIA showing an increase production for the lower 48 of 163 Bbl/d, meaning the US production is beginning to rebound even through the continued glut environment. It seems the $40-$50 range was enough for shale players to begin adding back production. This combined with OPEC’s insistence on pumping more crude and the inability to come to a production freeze or cut will likely see oil prices languish in the low $40s into the New Year, if not lower. This of course barring any agreement reaching in the November 30th meeting, which would see oil rise higher for a for the short to medium term.

Trump and Yields

The result of the US election – a Trump victory also lead to spike in US yields, a precursor to tax cuts and deficit spending policy proposed by Donald Trump. This has been the main driver of declining junk bond prices. As government debt becomes more attractive to new investors, require a higher yield for the junk bonds, leading the prices lower.

The proposed policies may be a little too aggressive, difficult for politicians in the House and Senate to digest and may be downgraded in size and scope. The risk of further selling in the bond market remains and is to the downside, but demand for bonds will stabilize as yields become more attractive in real terms as inflation has not yet picked up significantly and Trump doesn’t enter the oval office until January, let alone proposing and passing new policies.

 

Taking a look at the largest junk bond ETF, HYG, bearish derivative position have continued to build with almost 4x puts outstanding vs. calls. With overall puts outstanding rising above the number reached during the January/February lows.

HYG Outstanding Options Positions

There may be an opportunity to add more of these bonds in the coming weeks, as the market overreacts and positions itself too aggressively short on fixed income.

Fixed Income Investment Idea

For Canadian investors, pairing XHY with ZPR could provide an interesting combination for the fixed income portion of the portfolio, as it would to a large degree neutralize interest rate risk. As yields continue to rise, the prospects for higher resets on ZPR will see the price rising, while XHY will continue to fall with further as yields rise.

This phenomenon began materializing in the weeks before the election as seen in the chart below. With both assets moving about 4%.

XHY & ZPR Relationship 1M

Furthermore when looking at junk bond ETFs, HYG and XHY.TO, we see that they are currently trading ~2% discount NAV. Meaning on Friday investors were willing to sell at a 2% discount to portfolio value. In essence you are receiving a free 2% upside by buying the assets at a discounted value and it would be beneficial to purchase these two ETFs if you have a high conviction on their performance. This is especially relevant on the consideration that both of these ETFs traded only 3-4 times at these discounts to NAV in the previous 2 years and in all cases signaled a relative bottom.