USHY Sees Risk From Rates Not Accomplishing Inflation Smash

The iShares Broad USD High Yield Corporate Bond (BATS:USHY) ETF is a mouthful, but it has some apparent appeal. Being a fixed income ETF, it offers just that on the face of it, fixed income. Coupons streaming in from a very broad and diversified holding of USD corporate bonds. FX risks for US investors are limited here, which is a start, but before investors jump at the 8% yield they should consider a couple of macroeconomic factors that influence how compelling this bond actually is. Rates are rising and the trade in for disinflation is not clear yet. Several things confound the picture. While in theory, the reversal of inflationary spiraling should be good for fixed income, meaning USHY isn't necessarily a bad play, it could end up being one.

Comments on Macro

Let's begin with the evolution of our thoughts on macro. Assuming as a starting point that inflation is only a demand-side issue, which it isn't, would require about a base risk-free rate of 6% to stop it. This is assuming that the recovery in the less commodity-intensive service economy doesn't take place. Since that service recovery is coming in quite strong, the risk-free rate might only need to be about 4%. Currently, the 10y Treasury yields about 2.7%, so we're not far under those circumstances. The problem is that these rate increases will not translate fully to inflation reduction because the problem is also supply side linked to real factors, some of them currently geopolitical. Therefore, the hit to demand would have to be more so than to normalise it to a pre-COVID situation. Real economic value destruction from economic disintegration and more conservative inventory management leading to worse cash flows has to have its reckoning on the size of the economy. Since the economic realities could be more disruptive if they would be allowed to correct spending by the invisible hand rate increases to curb inflation and spending to account for the real loss in value would have to be even higher, or in other words, the current rate increases won't trade in for sufficient disinflation.

Look at USHY

The concern is that if rates rise more than inflation can be stopped, and rates have already gone up 2% (at least the Fed funds rate) in this current rate hiking cycle, with expectation of at least another 0.5% increase in the September meeting. If disinflation isn't accomplished, then real rates rise and hurt the value of fixed income securities. With the unwinding of inflationary vicious cycles, this trade-off would ordinarily be at least one-to-one and ultimately positive for fixed income, but the problem is cost-push factors. Therefore, this fundamental lack of clarity makes USHY risky in our eyes, which relies substantially on fixed coupon bonds. What makes USHY slightly worse off on top of that is that it is exposed to consumer cyclical exposures, which is certainly the most exposed part of the economy in a rate hiking environment. So there's even a credit quality risk to be a bit worried about, especially when consumer cyclicals, represented meaningfully by automotive, were already having problems on the supply side before their levered demand side could be hit.

Conclusions

So the bet becomes on how rate increases will trade in for inflation, and then to some extent how consumer cyclicals will be affected by the consequences on disposable income, which translates into a credit problem for the ETF. A mitigating factor is that there is news that Asian refiners are seeing hits to product spreads, which could eventually lead to run cuts and a fall in oil prices. This would do a good deal to resolve some of the exogenous factors exacerbating inflation and would be good for the prospects of a fixed income ETF like USHY. But besides that speculative element, there are some risks here that would be best avoided. If looking for yield, REITs are generally safer because at least leases get ratcheted up to not lose too much ground to rising real rates.

While we don't often do macroeconomic opinions, we do occasionally on our marketplace service here on Seeking Alpha, The Value Lab. We focus on long-only value ideas, where we try to find international mispriced equities and target a portfolio yield of about 4%. We've done really well for ourselves over the last 5 years, but it took getting our hands dirty in international markets. If you are a value-investor, serious about protecting your wealth, us at the Value Lab might be of inspiration. Give our no-strings-attached free trial a try to see if it's for you.