You Are Using HYG and JNK All Wrong, Here Is What To Do About It

Historically junk bonds, also known as high yield bonds, correlate quite well with equities. In fact we have built timing systems that use junk bonds as a trend confirmation indicator that have done quite well from a historical perspective.  Because of all this we, as well as half the internet, love that the junk bond ETF’s HYG and JNK exist. They are both great trading vehicles and a fantastic aid in our intermarket analysis and to measure investor risk sentiment in both the equity and bond markets.  All that said there are two major ways in in which we see them misused all the time.

First lets look at charts of the SP500 and HYG. As you can see in the chart below the SP500 as represented by SPY has been trending higher despite the almost 10% pullback in October. In fact it is at new all time highs right now.

SPY-SP500 ETF Total Return

Next we have a chart of HYG. As you can see it has been diverging from the SP500 since the end of June and has been sloppily trending lower ever since.

HYG-IBOXX Junk Bond ETF Total Return

Many analysts and traders have been posting these charts and saying that since there is a growing divergence between junk bonds and equities that we have to see a move lower in equities to bring things back into line. There are potentially a lot of things wrong with this statement but the one we want to look at right now is the idea that they are diverging. If virtually ALL the stocks in the SP500 were moving up and virtually ALL the bonds in HYG were moving down then we would indeed be worried about a major divergence. Rarely does investor sentiment go all in on equities and all out on junk bonds or vice versa.

So what is the problem? We don’t see a real divergence.  The secret is that not all of the stocks or all of the bonds are diverging.  If we look at an industry group breakdown we see something very important, namely that almost 15% of it is made up of oil and gas companies.  Do you think it might be important to know that the highest industry weighting is made up of a sector of the market that has been gored by the bears in the woods?

HYG Industry Group Breakdown

In fact if we look at a performance chart of the above groups we can see that there is not a real divergence. Over the past six months stocks have gone higher, junk bonds are basically flat, and oil and gas stocks have been absolutely hammered. Consequently in our view this is NOT a bearish divergence as most junk bonds are not dropping in the face of a rising stock market but instead only the oil and gas junk bonds are dropping.

SPY HYG JNK Oil Gas Performance Chart

While the above can be said to be up for debate we think the case is fairly solid that this so called divergence is less indicative than most seem to think. The next issue with how people use HYG and JNK is far less debatable.  Have you seen any of these charts showing the ratio between HYG and TLT? Most people use it to gauge investor sentiment. Are investors running to safety in Treasuries or are they going to the opposite end of the fixed income risk spectrum and buying junk bonds?  We think the concept is completely valid but the implementation is less so.

Here is a chart of the ratio of HYG and TLT. As you can see it has been trending downward for all of 2014 as long term Treasuries have vastly outperformed their junk bond cousins.  The problem is that usually you want to compare first or second cousins and not tenth cousins.

HYG and TLT Ratio

If you just went WTF is this guy talking about we don’t blame you, so let me explain.  In the bond world there is a thing called maturity which is simply how long until the bond is paid back.  TLT is a 20+ year bond ETF which means that it is full of bonds that end in 20+ years. In fact 90% of TLT is comprised of 25+ year Treasuries.  Where the HYG/TLT ratio breaks down is when we then look at the HYG or JNK maturity profiles.  As you can see in the table below 95% of HYG is comprised of 1-10 year bonds with less than 3% being more than 10 years.

HYG Maturity Profile

HYG Maturity Profile

The story is much the same with JNK as almost 94% of the bonds in JNK have a maturity of 3-10 years. And just like HYG, less than 3% is made up of bonds with maturities over 10 years.

JNK Maturity Profile

JNK Maturity Profile

So while the idea of a junk bond/Treasury bond ratio is great, using TLT as the Treasury component is less than ideal as the maturity mismatch is so large.  Lucky for us there are several other Treasury ETF’s and they are made up with ranges of maturity. TLT is 20+ years but did you know that IEF is a 7-10 year ETF and IEI is a 3-7 year ETF.  Either of these would be a far better choice for this indicator than TLT as we are able to compare first or second cousins instead of tenth cousins.

So what are these more accurately matched up ratios saying now? HYG/IEF shows that fixed income investors were happy to own junk bonds for the first half of the year and since then junk bonds have drastically under-performed.   Of course since the oil and gas sectors took their dive at the same time it is up to you to decide if the under-performance of junk bonds is as bearish as it usually it. We are discounting it but are still wary.

HYG and IEF Ratio

Looking at the HYG/IEI ratio things are even less bearish as the downtrend has been both shorter and less damaging.  Like above we think that the under-performance in junk bonds has largely been in the oil patch with other sectors barely affected. Consequently we are wary and yet modestly bullish on risk.

HYG and IEI Ratio

ETF’s, indices, securities, and other indicators are all well and good but it is important to look under the hood as much as possible so that you are drawing the right conclusions.  In this case you can decide if you should discount the under-performance of oil and gas and the subsequent divergence between junk bonds and stocks but we think that anyone that looks at the Junk/Treasury ratio needs to be using a proper maturity comparison or they are doing it wrong.

Happy Trading,

Take a $1 trial of The Macro Trader to receive unbiased actionable research

Currency Wars, Blah, Blah, Blah

Are you as sick of the term “Currency Wars” as we are? The book by Jim Rickards is timely and definitely worth reading but these days the term has gotten out of control. It’s as if the media just found out about competitive devaluation. If we look up “currency war” on Google Trends we get this chart showing that this is the second time the term has gotten out of hand. (Click on chart to enlarge)

Currency Wars-google trends

Most of the fuss, we actually like the term hullabaloo, has been regarding Abe over in Japan and the Yen’s free fall against pretty much everything. What is funny is that when you put this move into perspective the correct adjective goes from “war” to something closer to “heated discussion”. Here is the USD/JPY from 1972-now. (Click on chart to enlarge)

USD-JPY 1972 to Now

Do you remember everyone getting mad at the 76% rise from almost 325 down to 75? The Japanese must have been playing out their evil plot to make their exports less and less competitive right? Maybe not. What about the past 15 years or so. Surely we would remember if the Yen was getting too expensive and the hullabaloo surrounding the huge rise right? Well from 1998 to now the Yen is still up 34% from its 1998 low of 145. (Click on the chart below to enlarge)

USD-JPY 1998 to now

What about the past six plus years? If anything had happened in that time period we would certainly have had “currency wars” fresh in our heads right? Once again the world, or at least the media, must have missed the meme as those evil folks at the BoJ kept taking the Yen 37% higher from 120 down to almost 75 against the USD. (Click on chart to enlarge)

USD-JPY 2007 to now

Of course this meme didn’t really pick up steam until the current move where the Yen actually dropped 23% in five months. Apparently when the Yen is getting stronger the speed or magnitude does not matter but when it is getting weaker they are evil currency manipulators. Is there a currency war going on? The answer is of course yes. Are the Japanese responsible for it? The answer is of course no, at least not any more that the rest of the central banks out there that do what their “economies need” even if the actions have direct implications in the currency markets. (Click on chart to enlarge)

USD-JPY October 2012 to Jan 2013

Happy Trading,

Take a $1 trial of The Macro Trader to receive unbiased actionable research


All I Want For Christmas

With Christmas only hours away we thought it appropriate to give Santa something to mull over as he flies around the world giving all the good kids presents. Here is our Christmas list and to hoping that we were good enough this year to get any of them.

-European leaders to realize that this is more than a liquidity problem. Alternatively for European leaders to lead instead of the ridiculous statements that have been coming out of that continent for over year now.

-Democrats and Republicans to find some competence. Currently they seem to be trying to make stupid seem smart. We realize that this is a tall order for Santa but if we got this present we would be content for years.

-Correlations to drop. This past year everything has been trading with a correlation of either 1 or -1, neither of which is conducive to directional trading. We like buying good industry groups, shorting bad ones, buying certain commodities, and selling others. This past year has had us either buying “risk” assets or buying USD and Treasuries. Santa please fix it as this is getting old.

-For the hyper inflationistas to STFU. Yeah we said it. I am completely sick of people like Peter Schiff coming on my TV and radio to tell me that hyper inflation is hiding right around the corner. You have been yelling for four years and so far we have had mild inflation at best. Please Santa if you would like to shut these people up it would be a great Christmas and New Year.

-Teach financial writers how to write headlines. “Market is down .01% on housing numbers.” If the market barely moved then why do you have to apply a reason for it? Just say that the market is up x% today and then list off what happened that day. We don’t need a made up reason that only annoys us.

-An Energy Policy. We realize that this present is as hard to deliver. After all since WW2 every single president has said that we will be energy independent in X amount of years and yet after they are in office they do nothing, absolutely nothing. Even though we realize that this present can’t fit under the tree it would be amazing to finally get it.

That’s it. We already have our Red Ryder BB gun, our Radio Flyer wagon, a snuggy, etc. This Christmas we would love for some of these problems to at least be addressed if not solved. World Peace would also be awesome but we would be more than happy to settle for any and/or all of the above.

Happy Trading,

Take a $1 trial of The Macro Trader to receive unbiased actionable research


The State Of Global Macro-And Other Random Stuff

We saw this headline-

August is another cruel month for hedge funds-(Reuters) – Most hedge funds lost money again in August as hundreds of managers, including some of the industry’s best-known names, stumbled when stock markets swooned anew.

-and then we laughed.

Hedge Funds are no more an asset class than mutual funds are. There are several “general” classes of funds investing in anything from stocks to bonds to art. Long, short, long and short, arbitrage, levered, etc. There are a gazillion different strategies that are employed so headlines like the above are not helpful for much more then a useless sound bite. But onto the part that we actually liked.

One line mentioned how Global Macro was up 2.16% for the month of August which would indicate something less then cruelty for hedge funds, including some of the industry’s best-known names, but hey that’s just us. Anyways how is Global Macro actually doing? Well depending upon which macro index you use the numbers will be a bit different but for the most part this specific corner of the market is flat give or take a percent or so. While we, we being our newsletter The Macro Trader, do not try and hug our benchmark it would appear as though this year we have. In the table and chart below we show how our newsletter had done against the HFRXM and SP500 indexes. The table has the raw numbers and the chart has the performance of $1,000 year to date. (Click on charts and tables to enlarge)


$1,000 Invested Year To Date

How do we explain our relatively high correlation to the HFRXM Macro Index? Well we think that the next chart probably does a good job of answering this question. But in case the chart is not clear enough the answer is risk management. Global macro as an asset class has long held up well in any market with a penchant for bad markets. In other words we tend to outperform in bad markets and do decent in good markets. In the chart below you can see how our drawdowns compare to the SP500. (Click on chart to enlarge)

Drawdowns Year To Date

A few other observations that may or may not have anything at all to do with the initial subject of this post-

-We have seen few opportunities this year that have warranted an oversize allocation

-The SP500 is way to risky for the returns that it generates

-If markets are efficient how was the SP500 above 1250 for almost a year and then at 1100 a few weeks later

-There is no reason that you need to do what everyone else is doing

-Bill Gross is smart but he too can be wrong

-Warren B is also smart and can also be wrong

-95% of news is noise but we read it all in hopes of recognizing the 5%

-Anyone with the nickname Helicopter Ben is just looking for reasons to drop money from the sky

-If you aren’t at least semi-comfortable in Excel there is a high likelihood that you do not even know what due diligence is

-It is clean looking but so far Google+ is not Facebook

-More Money Than God is a great book

-The New Market Wizard interview of Stanley Druckenmiller is read by this author at least once every month or two

-Major bottoms and tops take more then a few days to form

-Yellowstone is awesome and everyone in America should go at least once every five years

Have a great Labor Day Weekend!!!!!!!!!!!!!!

Happy Trading,

Disclaimer-We are long Friday both the day and the excellent song by Rebecca Black .

Take a $1 trial of The Macro Trader to receive unbiased actionable research


Annual subscription $395.00 per year

Quarterly subscription $124.95 every 3 months