(August 2012) Recently one of our favorite bloggers came out with a piece “The US High Yield Market Looks Overheated.” There are some compelling arguments and data in the piece to back up that view, which we will not take the other side of. What we will do however, is point out that if you are going to be in bonds, there is a strong argument that high yield is still the place to be. In fact, Learn Bonds believes that junk bonds (non-investment grade but still rated) will provide returns that are at least 2% per year higher than investment grade bonds for at least the next few years.
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To do a quick and dirty analysis of the expected return for junk bonds, all you need to do is look at the yield and subtract the default rate (read why here). Here is a chart which shows the credit spread of high yield bonds vs. the default rate of high yield bonds since 1997. The credit spread simply measures how much more high yield bonds yield than treasuries of similar maturities (read more on the basics of credit spreads here).
Sources: Moody’s, BofA Merrill Lynch US High Yield Master II Option Adjusted Spread
What can we learn from this chart?
- Currently, the Credit Spread minus the default rate for junk bonds is a little bit higher than 4.0%. If the default rate and credit spread did not change in the future, an investor would earn over 4.0% more per year by investing in junk bonds versus treasuries.
- This level is extremely high by historical levels. With the exception of 2008 when yields on junk bonds were rapidly rising in anticipation large defaults rates, the difference between the credit spread and the default rate is the highest in 2011 & 2012.
- The reason for the this difference may not be fundamentally driven. The credit spread seems to both lag the default rate and get stuck at certain levels. Between 1997 and 2001, you can clearly see the credit spread lagging behind as default rates rose. The same behavior occurred as default rates fell between 2001 – 2004. When there is not a strong trend in default rates, the credit spread seems to get stuck. The credit spread was stuck in a narrow range during 2004 – 2007 and again in 2009 -2012, when default rates were modestly falling or flat.
How does this compare to Investment Grade Corporate Bonds?
Currently, the credit spread for Investment Grade Corporate bonds is only 2%. In other words, the credit spread minus the default rate for junk bonds is 2% higher than the investment grade corporate bond credit spread. For junk bonds to be a worse investment than investment grade bonds, the default rate would have to climb more than 2% from its current level. One of the reasons why we do not think that will happen is that the weakest companies were forced to default in 2008-9, leaving a stronger group of companies which are less likely to default. The difference between the default rate and the credit spread gives junk bond investors a rare opportunity.
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