Investors Beware: Dangerous Curve In High Yield

We are living in unusual times and two sets of high yield bond metrics prove it.

High Yield Spread Curve

The high yield spread is the difference in yield between speculative grade bonds and Treasury bonds. It represents the extra interest income that investors receive as compensation for high yield issues’ greater credit risk and lesser tradability, compared to Treasurys. The spread can be measured at various points along the maturity spectrum. For present purposes, let’s define the spread curve as the average spread on the longest issues, 15-plus years, minus the average spread on the shortest ones, 1-3 years.[1]

In all months since the inception of ICE BofAML’s maturity-based subindexes at the end of 1996, the spread curve has been negative 83% of the time. Of the 46 months in which the curve was positive, that is, when  the spread on 15-plus year bonds was wider than on 1-3 year bonds, 20 were concentrated in the 2006-2007 run-up to the Global Financial Crisis. Outside of that highly unusual period, the spread curve was negative almost 90% of the time. Currently, the spread curve is positive, a condition that generally occurs only when the reward for taking credit risk is meager.

Why is the spread on short-term high yield bonds normally wider than on long-term ones? In the event of bankruptcy, holders of the issuer’s one-year and 30-year bonds have equivalent claims for recovery as a percentage of face amount. Therefore, when a default appears highly likely, yield becomes irrelevant. Both the short-dated and the long-dated bond will trade at the same, deeply discounted dollar price.

Suppose that price is 60. Basic bond math states that in order for a bond close to maturity (the one-year-issue) to trade at 60, its yield must be much higher than the 30-year bond’s. By extension, the shorter-maturity bond must also have a much wider spread-versus-Treasurys.

In ordinary times, investors recognize that any speculative grade bond could be at high risk of default within a few years. They therefore factor into the spreads they demand today the possibility, however small, that the one-year bond will trade at a dramatically wider spread than the 30-year bond, if and when default risk sharply escalates. This reasoning ordinarily produces a negative spread curve. Only when investors all but ignore the possibility of future defaults do they accept a smaller spread on short-dated issues than on long-dated ones.

Recession Probability

That is how things stand today. Investors’ present, relative indifference to default risk is corroborated by a second line of analysis. The spread on the high yield index as a whole, comprising all maturities, is currently just 401 basis points (1 basis point = 1/100 of a percent).  That is where the spread normally stands when the economists put a 7.5% probability on a U.S. recession within 12 months. Currently, the median estimate of recession-probability among economists surveyed by Bloomberg is 25%. The gap between the recession risk that the high yield market is discounting and what economists perceive has not been this wide since 2008.

Investment Implications

Two separate analyses are currently sending the same message:  The high yield market is paying investors very skimpily for taking credit risk. This is not to say that the default rate is about to skyrocket or that prices will plummet next week. The preceding analysis does suggest, however, that this is not the most opportune time to make a major, new investment in high-yield bonds. Buyers will obtain better value when prices reflect more fear than they do today.

—–

[1] The ICE BofAML Indexes in this analysis are the U.S. Treasury Index, the 10-15 Year Cash Pay High Yield Index and the 1-3 Year Cash Pay High Yield Index, all used with permission.

 

source: forbes.com