Risk Appetite Warnings, Gone Wrong

Cam Hui | Jul 23, 2014 01:16AM ET

Investment manager examples is to compare the relative performance of the junk bond ETF (iShares H/Y Corporate Bond (ARCA:HYG)) to the long Treasury ETF (iShares Barclays 20+ Year Treasury (ARCA:TLT)). As the chart below shows, the HYG-TLT ratio (in purple) started to roll over in January, while the stock market (in black) continued to advance. This analysis suggests a negative divergence that represents a warning of declining risk appetite.

Nothing could be further from the truth. The HYG-TLT ratio is a relative price performance chart. As good bond investors know, price performance of a bond portfolio comes from principally two factors:

Interest rate sensitivity (duration)

Changes in credit spreads

I will show that the HYG-TLT ratio rollover is more a function of the first factor than the second. As the bottom panel shows, the yield of the long Treasury bond has been declining since January and coincides with the underperformance of HYG against TLT.

A bond math primer

First, here is a little bond math. The interest rate sensitivity of the price of a bond is a function of its duration . Here is the formula for Macaulay duration, but the math-phobic need not worry too much about what the Greek letters lounging on their sides mean.

Here are the important properties of duration that you need to know:

The longer the duration, the more sensitive the price is to changes in interest rates

For bonds with equal coupons, a longer maturity bond will have a longer duration

For bonds with equal maturities, a lower coupon bond will have a longer duration

Putting this concept into practice, I went to iShares and looked up the duration of TLT, which came to 16.9 years.

iShares also showed the duration of HYG to be 4.0 years. These two ETFs have a serious duration mismatch. It was that duration mismatch that mainly accounted for the differential in performance when interest rates started to fall in January.

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A better Treasury comparison for HYG would be iShares Barclays 3-7 Year Treasury Bond (ARCA:IEI), the 3-7 year Treasury ETF, with a duration of 4.5 years:

Better measures of risk appetite in bonds
With that analysis in mind, here is the HYG-IEI ratio as a better measure of risk appetite as duration risk between the two ETFs have been minimized. The relative uptrend of HYG to IEI was broken and turned down only this month, not in January as the HYG-TLT ratio showed. This broken relative uptrend represents an early warning of declining risk appetite that needs to be watched and confirmed by other indicators. The downturn in the HYG-TLT ratio was a false alarm.

On the other hand, the relative performance chart of the Emerging Market bond ETF (NYSE:EMB), with a duration of 7.1 years, against the 7-10 year Treasury ETF (ARCA:IEF), with a duration of 7.6 years, shows that the EMB-IEF ratio staged a relative upside breakout and is now consolidating just about the breakout zone. While the EMB-IEF ratio readings have been far more volatile, its behavior has not confirmed the risk appetite rollover in the HYG-IEI ratio.

In conclusion, I staged this exercise as an illustration of what Jane Hwangbo wrote. Even if you are one of the "cool kids", you need to continually "ask dumb-sounding questions to...accumulate a fresh knowledge base". That's why I remain a "humble" student of the markets.

Disclaimer: Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.
None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Written By: Cam Hui

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