A pile of junk
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Junk Debt Sees Big Outflows in HYG: Will NFP Numbers Reward Buyers?

By:Thomas Westwater

A Potential Floor Ahead of U.S. Jobs Numbers

  • The junk bond market selloff is not over.
  • Corporate debt remains at risk even with a Fed pivot, due to the economic malaise caused by the Fed's tightening cycle.
  • HYG is at an inherent disadvantage vs. TLT, which is composed of safer debt.

Is the junk bond market selloff over?

The bound rout paused today while traders waited for the highly anticipated nonfarm payrolls report, otherwise known as the NFP, which was due Friday morning. The Federal Reserve uses this report as a critical input for decision making. It is currently triggering the bond selloff because of the "higher-for-longer" narrative that has spread into financial markets.

The Treasury market has experienced this more than any other part in the financial markets. Although short-term rates—the ones more sensitive to monetary policy moves—remain relatively calm, the threat of higher borrowing costs becoming permanent in the economy darkens the economic outlook. These fears are evident when we observe long-term bonds (/ZN and /ZB).

In the weeks following September's meeting of the Federal Open Market Committee, or FOMC, corporate debt experienced a notable selloff. Corporate bonds declare, “The recession is imminent.” But does it really? By examining the performance between Treasuries and corporate debt, we might predict an answer to that question.

This week, the iShares 20+ Year Treasury Bond Exchange-Traded Fund, also recognized by its ticker symbol TLT, has declined over 3%, which followed a 3% reduction the week before. Meanwhile, during the same reference periods, HYG has seen a selloff.

However, price performance tells only part of the story. Fund flows have remained relatively strong for TLT, as bond traders bet on a turnaround point in Federal Reserve policy. Alternatively, HYG is seeing heavy weekly outflows—with this week on track to record the biggest negative fund flow since July (see chart below).

Yesterday, HYG also saw one of its highest daily trading volumes on record, trading nearly 140 million shares vs. an average of about 36 million shares per day. That was on an up day, which signals some bullish appetite for the ETF, or exchange-traded fund, around the 72 price level.

The message traders are seeing—in my view—is this: the Fed will eventually pivot, and when it does, Treasuries will catch a bid. A cohort of traders are betting they can catch the turning point, which helps to stem fund flows out of TLT.

HYG, however, is at a disadvantage. Even with a Fed pivot, corporate debt will remain at risk for some time as the economic malaise caused by the Fed’s tightening cycle continues. This puts HYG at an inherent disadvantage vs. TLT, which is composed of safer debt. Will Friday’s NFP numbers save corporate debt if the numbers come in short?

HYG ETF Fund Flows

What’s the trade on HYG?

The recent decline in bonds, particularly in junk debt, has caused a spike in volatility. That bodes well for those looking to collect premium on the instrument. Currently, HYG holds an implied volatility rank (IVR) of 32.5. That said, selling a put spread makes sense for those who may want to get into a long position at the current levels. For those betting on further selling, a short call spread may offer some attractive premium.

HYG Chart

Thomas Westwater, a tastylive financial writer and analyst, has eight years of markets and trading experience. @fxwestwater 

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