Diary of a Financier

Begrudgingly, Evidence Supports High Yield Outperforming through January

In Capital Markets on Mon 20 Dec 2010 at 17:02
  • I’d love to play contrarian, but my analysis suggests HYG poised to outperform LQD.
  • If the charts hold-up, I’ll pair long HYG with short LQD.

When I started this entry, I set out to disprove the High Yield corporate bond hype.  I’m agitated when retail brokers regurgitate [I mean, repeat] after their analysts, so I wanted to build a case against them.  In the end, my analysis merely supports their case.

We caught the divergence in corporate bond indices headed into this fixed income downturn since November.  We even noted High Yield’s (HYG) relative strength to Investment Grade (LQD) through the recent round of Euro woes.  Nevertheless, we didn’t want to interrupt our ladders, so we chose to play the outlook by reeling in duration before putting on a two-pronged pair trade to barbell the Treasury curve (using ETFs, we’re long the front & back-end of the curve, short the intermediate).  That’s worked satisfactorily.

Now, I’m hearing so many analysts and pundits touting “risk up”–their Junk bond rally cry from the old word-bank–that some of my retail colleagues have started reciting the argument on their sales calls:

‘People are chasing yield with the expectation of inflation and Fed tightening in 2011.’

‘Puh-lease,’ I want to respond.  Yes, High Yield has enjoyed a notably shallow fall from highs, while Investment Grade has left a deep crater at the end of its own chart.  Although, an elastic snap-back is what happens when you have a 2-sigma spike in a low-volatility asset class.  Perhaps its statistics; perhaps it’s Newton’s Third Law of Motion; either way, it’s amazing how Markets replicate the laws of other disciplines.

LQD v HYG 1-year chart

So, weighing the retail money’s High Yield bullishness along with the crater in Investment Grade performance, I decided to take a gander at the charts.  One of the best ways to test an investment idea is to find support of its null hypothesis.  Along those lines, the short-term charts nominates HYG as the safer play du jour:

HYG daily

LQD daily chart

I’m not taking any new positions in either asset class, but the short-term outperformance of HYG is undeniable, particularly with MACD & Slow Stochastic staving off the devastating lows tested by LQD.  In addition, note the 50-day Moving Average in LQD that’s crashing down on its 200 DMA (as opposed to a perfectly stable 50 DMA shown by HYG).

I always look for confirmation in longer-term (weekly) charts to back my short-term conclusions.  Therein, I’m a bit less confident in the null:

HYG weekly chart

LQD weekly chart

The only caveat in the HYG v LQD weekly comparison is the SStochastics, of which HYG’s is diving, while LQD’s is about to bullishly cross 20.

Overall, I’ve found significant evidence in support of HYG.  If I were to act on these findings, I would pair a long HYG position with a short LQD to profit from the spread tightening.  Given HYG’s relative strength, the pair trade provides insulation from that overarching theme, “the end of the 30-year fixed income bull.”  I would feel comfortable opening the pair if the following criteria are fulfilled:

  1. LQD weekly MACD failing to stay above zero.
  2. HYG daily MACD passes up through zero with SStochastic & RSI continuing their climb.
  3. HYG weekly MACD stays above zero with SStoch & RSI maintaining bullish footing.

Stay tuned to the Trading Desk for updates.

–Romeo

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  1. […] pair trade per prior analysis: Long HYG, Short […]

  2. […] in December, I paired a long High Yield (HYG) position with a short Investment Grade (LQD) because I saw confirmation of a divergence.  The trade has worked out famously, reaping 2.95% total return to date (including […]

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