HYS ETF: Beware Rate Cutting Cycles (NYSEARCA:HYS)

I came across the PIMCO 0-5 Year High Yield Corporate Bond Index ETF (NYSEARCA:HYS) while screening for potential beneficiaries of the Federal Reserve’s upcoming policy rate cuts.

Since the HYS ETF has modest amounts of duration exposure, it should benefit from the pending interest rate cut. However, taking a step back, investors should ask ‘why is the Federal Reserve cutting interest rates’?

The Federal Reserve cut policy rates in response to economic slowdowns and recessions. Currently, the Federal Reserve is about to begin a rate cutting cycle because the labor market is rapidly deteriorating, with unemployment rising to 4.2% from a cycle low of 3.4% last year.

Historically, holding high-yield bonds into economic slowdowns have not been a winning strategy, as slowdowns/recessions coincide with a spike higher in credit spreads and defaults, which cause realized and unrealized losses to high-yield bonds.

In my opinion, investors should seize the opportunity to high-grade their portfolios while high-yield credit spreads are still benign. I rate the HYS ETF a sell.

Fund Overview

The PIMCO 0-5 Year US High Yield Corporate Bond Index ETF is a fairly easy-to-understand fund. It tracks the BofA Merrill Lynch 0-5 Year US High Yield Constrained Index (“Index”) and provides investors with exposure to USD-denominated, short-duration high-yield bonds.

The HYS ETF charges a relatively expensive 0.56% expense ratio and has $1.3 billion in AUM (Figure 1).

Portfolio Holdings

True to its mandate, the HYS ETF holds securities that predominantly mature within 0-5 years, with 43% of the portfolio maturing with 1-3 years, and 54% maturing 3-5 years (Figure 2). This gives HYS an effective duration of 2.2 years.

HYS’ portfolio has a modest amount of internal leverage (short 8% in securities) while 38% of the portfolio is BB-rated, 35% is B-rated, and 11% is CCC-rated (Figure 3).

Overall, the HYS ETF appears to be a fairly vanilla high-yield bond fund.

Historical Returns

The HYS has delivered modest total returns, with 3/5/10Yr average annual returns of 4.1%/4.3%/4.1% respectively to August 31, 2024, and a since-inception (“SI”) average annual return of 4.8% (Figure 4) However, short-term returns have been strong, with 1-year returns of 11.3%.

Compared to the more popular iShares iBoxx $ High Yield Corporate Bond ETF (HYG) with 3/5/10Yr average annual returns of 2.0%/3.3%/5.6%, the HYS ETF appears to have outperformed (Figure 5).

HYS’ outperformance is primarily the result of its shorter duration of 2.2 years compared to 3.0 years for the HYG ETF, as the Federal Reserve’s interest rate increases in 2022/2023 created a headwind for longer-duration assets.

However, the HYS can also underperform the HYG ETF if interest rates are heading lower, as they did in 2018-2020 (Figure 6). So the choice of the HYS ETF vs. the HYG ETF for high-yield bond exposure depends on one’s view on the path of interest rates.

Distribution & Yield

In terms of distribution, the HYS ETF does pay an attractive monthly distribution, with a trailing twelve-month distribution yield of 7.2% (Figure 7).

HYS’ distribution should be fairly sustainable, given the fund earns an 30-Day SEC yield of 6.9% on its portfolio and has a portfolio yield-to-maturity (“YTM”) of 7.6% (Figure 8).

Pending Interest Rate Cut Argues For Duration Exposure

On the one hand, a pending interest rate cut from the Federal Reserve argues for investors to take on modest amounts of duration risk. Currently, there is a 75% probability that the Federal Reserve will cut by 25 bps in September, and a 25% probability they will cut by 50 bps (Figure 9).

When interest rates are falling, funds like HYS and HYG should experience a tailwind from their duration exposure.

But Beware Increased Credit Risks

However, on the other hand, policy rate cutting cycles tend to precede or coincide with recessions and increased credit risks, as shown by the spike higher in high-yield credit spreads during recessions (Figure 10).

So while the HYS may benefit initially from the Fed’s policy rate cut in September, as its duration exposure will lead to MTM gains, those gains may vanish rapidly if policy rate cuts are followed by an economic slowdown and a rapid rise in bankruptcies and defaults by companies.

Historically, owning high-yield bonds heading into a recession has not been a winning strategy, as shown by the HYG ETF suffering large MTM drawdowns during the 2008 and 2020 recessions (Figure 11).

Possible High Yield Alternatives To HYS

For me personally, I am advocating investors high-grade their investment portfolios ahead of a potential economic slowdown while credit spreads are still at cycle lows.

Instead of high-yield bond exposures, I recommend investors either look for investment grade bonds or high-grade collateralized loan obligation (“CLO”) securities like the Janus Henderson AAA CLO ETF (JAAA).

Historically, investment grade bonds have very low default rates, even during recessions (Figure 12).

Similarly, investment-grade CLO tranches have had very low default rates even during the 2008 and 2020 recessions (Figure 13).

As we head into an economic slowdown, I believe investors should shift their focus away from potential gains to avoiding potential losses.

I last wrote about the JAAA ETF here.

Conclusion

The PIMCO 0-5 Year High Yield Corporate Bond Index ETF should see an initial bump as the Federal Reserve is set to begin cutting policy interest rates in September. However, historically, policy rate cutting cycles precede or coincide with economic slowdowns and recessions, which can cause a spike in credit spreads and defaults.

I recommend investors high-grade their portfolio while credit spreads remain tight and rate the HYS ETF a sell.